Apple (AAPL) may be the most inefficient and wasteful company in America.
In terms of product development, marketing and distribution, Apple is certainly one of the most efficient companies in the world. Its extraordinarily high margins are unequivocal evidence of AAPL’s prowess in creating value through its core operations.
On the other hand, Apple may well be one of the most wasteful companies in the world in terms of its management of excess cash flow and cash balances. AAPL’s “cash management division” is a non-core operation that represents a shocking 71% of the firm’s total asset base. This “cash management subsidiary” is massively destroying value for the firm and for shareholders.
Apple’s remarkably low forward P/E ratio of roughly 11x and its extremely low PEG ratio of roughly 0.55 are extremely telling empirical indicators of Apple’s poor capital management with regards to excess cash flow and cash balances. They are testament to the fact that AAPL and its shareholders are being penalized for inefficient and wasteful capital management policies by AAPL’s management team.
FACTS ABOUT APPLE’S ASSET BASE
- According to Apple’s latest 10Q statement, Apple’s total asset base is valued at $106.8 billion dollars.
- AAPL’s hoard of cash and marketable securities are valued at roughly $76.2 billion dollars on the balance sheet.
- In other words, AAPL’s cash hoard represents roughly 71% of the company’s total asset base.
- Apple has vastly more cash and marketable securities on its books than core productive assets. The ratio is 7.1 to 2.9. That is 71% cash versus 29% core assets.
- Apple manages vastly more capital as a fixed income money manager than it does as a maker of consumer electronics.
APPLE USES EXPENSIVE RATHER THAN CHEAP CAPITAL
What do you say if a company makes investments employing capital that has a cost of 10%, when it could be employing capital that has a cost of 3%.
You would be correct if you said that this company is extremely wasteful.
This is exactly what Apple management is doing.
Apple finances all of its operations with equity capital and none with debt capital.
Apple’s cost of equity capital is around 9.9%. This can be derived in either of two ways. One could simply look at AAPL’s 12-month forward earnings yield that is currently at roughly 9.0%. Or one could calculate an equity cost of capital utilizing data on volatility, bond yields and historical equity risk premiums. The result also yields an equity cost of capital of around 9.9% (or higher).
By contrast, AAPL’s cost of long-term debt capital is probably not more than 3.5%. On an after-tax basis, this implies a net cost of debt of roughly 2.8%.
Thus, it is extremely wasteful for AAPL to be financing its operations with capital that costs 9.9% when it could be financing at least a substantial part of its operations with capital that costs 2.8%.
Due to management policies, Apple’s weighted average cost of capital (WACC) is substantially higher than it should be, thereby drastically reducing the economic value added or EVA generated by the firm, and therefore its value.
This is no mere theoretical matter. Apple’s wasteful capital management policy is costing shareholders many billions of dollars. I will quantify the loss in value that APPL’s policy is causing in a subsequent article.
APPLE REFUSES TO DISPOSE OF VALUE-DESTROYING ASSETS
What would you say if a company has assets that yield well below the company’s cost of capital?
You would be correct if you said that the company is destroying capital.
A firm which maintains assets that yield below the firm’s cost of capital is meeting the textbook definition of a firm that is destroying capital.
Apple is destroying capital hand-over-fist, by maintaining and refusing to dispose of assets that are yielding returns that are substantially below the firm’s cost of capital.
Apple’s cost of equity capital is roughly 9.9%. By contrast, the return on capital of Apple’s massive cash hoard is probably around 0.5%.
Apple’s refusal to dispose of value-destroying assets is lowering the firm’s overall return on invested capital, thereby impairing the overall value of the firm. This is reflected in the firm’s extremely low PE multiple, particularly if you analyze this PE multiple in the context of the firm’s operating profitability and profit growth rate.
What Apple is doing with its cash hoard is no different than what a company does when it refuses to dispose of assets that are yielding below the cost of capital. It is engaging in capital destruction. It is a textbook case of it.
DOES THE CASH HOARD HAVE STRATEGIC VALUE?
Some analysts have echoed Apple managements’ argument that the cash hoard represents some sort of asset with “strategic” value.
The way they describe it is akin to analogizing the cash hoard to a call option. The capital destruction here could be analogized to the time value decay of an option.
What Apple and the apologists of its capital management policy are essentially saying is that company management is willing to accept value destruction on $76 billion dollars, or 71% of its total asset base, at a rate of 9.4% per annum in order to preserve the option to use that cash in the future for some undisclosed purpose.
This argument is absurd on its face. What possible strategic purpose is this cash serving?
- Some say that the cash can be used for acquisitions. That is nonsense. AAPL does not need cash to make acquisitions. It can use its stock. Or much better yet, it can borrow money at a rate well below its cost of equity.
- Some people say that AAPL is stashing the money away for a rainy day. This is preposterous. What sort of an emergency is AAPL self-insuring against? (Note that the annual value destruction being analogized to an insurance premium). A $76 billion dollar “insurance policy” would literally allow the company to rebuild itself not just once, but two times over! If AAPL really wants to insure itself against future extinction it could do so much more cheaply by purchasing a guaranteed credit facility. AAPL could structure a guaranteed credit facility at an extremely low rate. This way, AAPL could ensure itself of cash in a cataclysmic emergency. Such a guarantee could be purchased for the equivalent of around 0.5% of the value of the credit line per annum. This would be much cheaper than the 9.4% per annum of value destruction that AAPL is currently engaging in.
In sum, AAPL management is frittering away company value at an alarming rate of around 9.4% per year on 71% of its asset base. This is the cost for the company of management preserving its “plaything” or “security blanket,” however you prefer to look at it.
This is not sound strategy. This is a strategic monstrosity.
HOW MUCH IS A CASH HOARDING BUSINESS WORTH?
What kind of valuation would you willing to assign for a company whose business plan consists of hoarding cash and investing it in securities that yield around 0.5%?
The answer is: You would not pay very much for such a company.
Indeed, you would probably pay less than the book value of its assets, given that the return on capital of the company, after expenses, would be dramatically below any benchmark that you would establish for cost of capital.
Yet this is the business plan that AAPL management is pursuing with 71% of the company’s assets! It is no wonder that AAPL sells at such a ridiculously low PEG ratio! Who wants to pay a premium valuation for a company that has 71 percent of its assets in a value destroying business?
Apple’s “cash management business” – essentially a management “plaything” or “security blanket” (depending on how you want to look at it) --is dragging down the firm’s overall returns on capital. As such, it is dragging down the overall multiples that investors are willing to pay for AAPL's earnings, cash flow and book value. Multiple studies have shown the definitive empirical link between valuation multiples and measures of return on capital (ROE, ROA, ROIC, ROCE, etc).
Many people are not used to thinking of cash as an asset that can destroy value. However, in excess, that is exactly what too much cash does. Too much cash increases the WACC and lowers the return on capital, thereby lowering capital efficiency and impairing economic value added (EVA).
Hoarding excess cash is virtually no different than stubbornly maintaining operating assets that return less that the firm’s cost of capital. The former destroys value just like the later.
Fortunately, AAPL is adding massive value to the company through its core operations. This has driven impressive shareholder returns in recent years.
However, that does not take away the fact that AAPL management is destroying value at an alarming rate through its non-core “money management division.”
In future articles I will try to quantify exactly how much value AAPL management is destroying as a result of its inefficient and wasteful capital management policy.
For now, I will only say this: Investors should not commit the mistake of concluding that just because a stock price is going up, that management can do no wrong. Nor should management success in key areas make them immune to constructive criticism. Management should be duly complemented for its work in areas in which they are adding value. Likewise, management should be taken to task for their actions in areas in which they are destroying value. The former does not minimize the latter, nor vice-versa. History shows that lionizing management for their virtues while coddling their vices is a long-term recipe for underperformance, and perhaps disaster.
Capital is a scarce resource. AAPL management is wasting it on a mass scale. Tragically, enthralled by AAPL’s brilliant successes in its core operations, most AAPL shareholders are “whistling past the graveyard” with regards to what is being done with 71% of the company’s assets. See this article, for ideas regarding what AAPL management should be doing.