Tuesday, July 12, 2011

Apple’s Cash Hoard

There’s a difference between how Apple is run and how most other companies are run. It’s extremely small but it affects everything at the company, from how it views Wall Street down to its products and everything in between.

Apple is run by people; its competitors are run by businessmen.

Look at RIM, a company I consider to be run by businessmen. It often makes decisions based on “partner requests or even legal advice.” There, for some reason, it also “takes guts” to not release unfinished products in order to meet quarterly numbers. But at Apple, according to a former executive who recently spoke to Fortune magazine, “Prototypes and demos always come before spreadsheets.”

(Google is another example of a company run by people instead of businessmen. Co-founder and CEO Larry Page made that clear in his original Owner’s Manual for Google shareholders: “We believe strongly that in the long term, we will be better served — as shareholders and in all other ways — by a company that does good things for the world even if we forgo some short term gains.”)

Apple, under the direction of Steve Jobs, has taken a unique approach to Wall Street and Apple’s share price. On May 26th, 2010, Apple overtook Microsoft in market capitalization and became the largest technology company in the world. Less than a week later, Kara Swisher asked him about the monumental event during an interview at the 8th annual All Things Digital Conference. Even though Steve called it a “surreal” moment for “those of us that have been in the industry a long time,” he also noted that it “doesn’t matter very much” because “it’s not what’s important” since “it’s not why any of our customers buy our products.” In a 2008 interview he did with Fortune magazine, he explained what is important at Apple: “We just want to make great products.”

And therein lies the secret to Apple’s incredible success in the stock market. The reason AAPL has done so well over the last 10 years is precisely because Apple hasn’t focused on its share price — and instead focused on making “beautifully designed products that are user centric and work how they are supposed to work.” As Fortune magazine put it: “Most companies view the P&L [Profit and Loss statement] as the ultimate proof of a manager’s accountability; Apple turns that dictum on its head by labeling P&L a distraction only the finance chief needs to consider.”

By focusing on the long term instead of the short term and by taking its time crafting new products instead of rushing them out the door in order to meet quarterly numbers, Apple’s share price has shot up more than 3000 percent over the last 10 years and has made Apple the second largest company on the planet, sitting behind only Exxon Mobil.

But Apple’s incredible success has also led to the accumulation of a massive $65.8 billion cash hoard that has come under fire lately. Yair Reiner, an analyst at Oppenheimer & Company, thinks Apple’s cash is “truly untenable,” and Toni Sacconaghi, an analyst at Sanford C. Bernstein & Company, feels Apple should pay a 4 percent dividend and initiate a $30 billion stock buyback to “mitigate investor fear of a potentially large, value destroying acquisition and create financial discipline,” which would, of course, ”create shareholder value.”

Right? 

No. As Horace Dediu pointed out, when technology companies institute stock buybacks, they don’t create a lot of shareholder value, if any at all. Microsoft has spent a little more than $97 billion on buybacks since 2004 and its share price has gone up less than 10 percent. Over the last 10 years, it has spent over $170 billion on both buybacks and dividends while MSFT has gone down 19.92 percent. At the same time, networking giant Cisco has returned $50.7 billion to shareholders since the beginning of 2004 while its share price has dropped 35.58 percent. Additionally, RIM’s stock price has plummeted 21.16 percent since it announced a share buyback program less than 30 days ago, on June 16th. Though other factors certainly could have played a part in the depreciation of the share prices of the aforementioned companies, using cash for stock buybacks and dividends clearly isn’t the best way to increase shareholder value.

So then how should Apple use its cash to increase shareholder value? 

Apple, despite what Toni Sacconaghi thinks, already shows far more financial discipline than most companies out there. It doesn’t spend for spending’s sake; Apple is very conservative with its cash and only uses it for strategic purchases.

In early 2005, Apple bought a company named FingerWorks for an undisclosed sum of money. The Multi-Touch technology Apple acquired through the acquisition lies at the heart of the iPhone, iPad, and iPod touch. Those three products have brought in around $100 billion in revenue and nearly $40 billion in profits over the last 4 years. No matter how much Apple paid for the company, it certainly got a better return on its investment than had it “created shareholder value” in traditional ways. 

Later that year, Apple announced that it was going to prepay $1.25 billion for flash memory chips in order to meet demand of its products going forward. Apple has renewed their flash memory contracts multiple times since then — and every time, they’ve payed in advance — in order to ensure adequate supply as the demand for its products continued to skyrocket. (This eventually led to a worldwide shortage of flash memory for Apple’s competitors.) When Bill Shope of Goldman Sachs asked Apple COO Tim Cook about how the recent disaster in Japan affected Apple’s supply chain (which includes flash memory) on Apple’s second fiscal quarter earnings call, Tim said that “we did not have any supply or cost impact in our fiscal Q2 as a result of the tragedy, and we currently do not anticipate any material supply or cost impact in our fiscal Q3.” During Apple’s first fiscal quarter earnings call, he said that prepaying for components is “an absolutely fantastic use of Apple’s cash” since it gives Apple so many advantages over its competitors.

Just this week, courts in the U.S. and Canada approved Apple’s purchase of Nortel’s 4G LTE patents. Regardless of whether or not you think a company should be able to purchase “outright ownership” of patents so vital to the future of technology from another company, the $2 billion purchase will definitely be returned to Apple shareholders in spades. The patents in question will no doubt be used in upcoming products as well as in patent litigation against competitors.

To summarize, Apple has used its cash to purchase small companies, to prepay for important components, and to buy patents. Though Apple didn’t “create shareholder value” in the traditional sense, using its cash in those three ways clearly benefited shareholders. AAPL currently trades at a little more than 10x what it did on January 1st, 2005, and I haven’t seen a single analyst that thinks Apple’s share price will go down.

But today’s Apple faces a different problem than the Apple of 2005. Yesterday’s Apple couldn’t secure enough components to meet demand; today’s Apple can’t make its products fast enough to meet demand. It’s a small but extremely important difference.

The iPad 2 was originally released on March 11th — 4 months ago — and yet demand still outstrips supply. As recently as 6 days ago there was a 1-2 week wait to buy one. Tim Cook described it as “the mother of all backlogs” since so many people “can’t wait to get their hands on it.”

For Apple’s hottest products, the question isn’t “How many can Apple sell?”

It’s “How many can Apple make?”

With that in mind, I think the most effective use of Apple’s cash would be to invest in production capabilities, which it seems Apple already does. Apparently, Apple uses its cash hoard to subsidize “the construction cost […] of [a] factory in exchange for exclusive rights to the output production of the factory for a set period of time (maybe 6 - 36 months), and then for a discounted rate afterwards.”

Since production bottlenecks limit how many products Apple can sell, it makes perfect sense to invest in production capabilities. The more products Apple’s contractors can produce, the more products Apple can sell, and the more value Apple creates for its shareholders.

So even though Apple “creates shareholder value” in a nontraditional way, it’s Apple’s way of doing it, and I definitely don’t have a problem with it. I’m more than happy with the performance of my 8 shares.