Apple Computer: Using Excess Cash as a Strategic Tool

Overview

Arik Hesseldahl of BusinessWeek.com wrote an interesting story concerning what Apple should do with a portion of its $12 billion cash hoard - namely, starting a $1 billion venture capital fund in lieu of doing large, risky acquisitions. This is certainly an interesting view, and one that is presumably not unfamiliar to Apple given its formation last year of an asset management subsidiary (named Braeburn Capital) in the tax haven of Reno, Nevada. That said, I think Arik - and Apple - need to take a big step back, and before considering whether or not to start an in-house venture capital fund answer the following questions:

1. What is the right amount of cash Apple should keep on-hand to cushion variability in free cash flow?
2. What is the process for benchmarking internal vs. external investment opportunities? Are there suitable analytical frameworks in place for making these assessments?
3. What is the current dollar value of projects - be they internal or external - that warrant investment, given the Company's ROI objectives?
4. In the event that additional cash exists beyond that required to fund 1 and 3 above, is this excess likely to be a durable phenomenon (e.g., indicating that a change in dividend policy might be appropriate) or a transient event (e.g., meaning an opportunistic stock buyback might be a better fit)?

Therefore, it seems to me that a quick discussion of optimal cash balance/business risk assessment, business development strategy and corporate finance policy is required before even considering whether or not to start an in-house VC effort. And, please note, the road is littered with corporate VC efforts gone awry, which should serve as the catalyst for some very deep thinking about how to structure such an inititative if, in fact, it is the right financial and strategic move for Apple.

Optimal Cash Balance - a study at the intersection of business risk and market risk

Let me qualify this discussion by saying that there is no one right way to compute this number, just as there is no one right way to calculate how large a bank's economic (as opposed to regulatory) reserves should be to given the risks inherent in its loan and trading portfolios. That said, there are a few core principles that need to be considered regardless of how one performs the actual analysis:

• Cyclicality/seasonality of operating cash flows
• Volatility of operating cash flows
• Impact of macroeconomic variables on corporate cash flows
• Impact of industry variables on corporate cash flows
• Error term - other risky variables

I actually wrote part of a post about this back in October, prompted by a Mark Hulbert piece in the New York Times titled "Behind Those Stockpiles of Corporate Cash." The key excerpts from Mark's article are as follows:

So what is the main cause of the climb in corporate cash? Upon analyzing a dozen factors that economic theory suggests could play a role, the professors found that the biggest was an increase in risk — as evidenced by factors like unpredictable cash flow. Corporations have become less able to count on steady cash flow from year to year, according to the professors, and despite the growth of a complex derivatives market, companies can’t adequately hedge this risk without holding more cash.

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To properly compare two companies on the basis of cash holdings, Professor Stulz says, you should first compare their risk, as measured by factors like the volatility of their cash flows. Only if a company is holding more cash than is justified by its risk can we conclude that it is genuinely more conservative.

I had a slightly out-of-body experience reading this, because I had done some work with a colleague at Deutsche Bank over six years ago that concluded the exact same things. I went on to write:

This analysis and their reasoning for why corporate cash balances have risen is absolutely spot-on. In the 1999-2000 period, when I ran a team in equity derivatives at Deutsche Bank, I worked with a fellow named Tim Opler (now of CSFB) on a framework for analyzing the "cost of financial distress" for a given company and, therefore, the optimal amount of cash to be held as a hedge. Tim, a former finance professor at Ohio State and SMU and a total brainiac, worked in the Liability Strategies Group at Deutsche and shared my passion for helping companies address this thorny issue. 

We essentially ran models that looked at precisely the things mentioned in the study above - namely, the volatility of a company's cash flows, its relationship to economic cycles, potential changes in business mix and its impact on the characteristics of future cash flows, quantifying what constituted "financial distress" and arriving at a recommendation for a base level of cash or near-cash that should be held to cover this risk. We specifically looked at companies that generated large amounts of cash - technology companies, telecommunications companies, regulated utilities, etc. - and advised managements on corporate finance policies like stock buybacks, dividends, and long-term debt issuance strategies. I will tell you that this type of analytical framework resonated with Treasurers and CFOs alike, and had a real impact on how many companies managed their cash - in some cases, gaining the comfort to increase their dividends/share buyback programs, while others chose to issue long-term debt to build the necessary cushion to most efficiently take the tail risk of financial distress off the table.

Suffice it to say, this is a very important input to any discussion of what a company should do with its cash. Does it have enough cash and near-cash to handle potential financial distress (which doesn't simply mean today's distress, but the probability of tomorrow's distress)? Does it have too much? If so, how much too much? These are exactly the questions Apple needs to answer before deciding what to do - otherwise they'll be gambling with shareholders' money in the absence of needed data, which would be a big mistake. Clearly $12 billion is more than Apple needs to hold in cash. But what is the right number - $3 billion? $5 billion? Inquiring minds want to know.

Build vs. Buy - it's all about ROI

I appreciate Arik's cynicism about large acquisitions - the data certainly supports his position. But what about small fill-in acquisitions? Purchases and licensing of technology? Joint ventures? All of these need to be considered relative to Apple's current development roadmap, which should guide which projects to pursue. The real question is how to best pursue them. This, again, boils down to necessary analytical rigor and frameworks with which to make such decisions. And at the core of these decisions is ROI. And ROI can't just be a number-crunching exercise, but one which takes into account the structure of the organization, the impacts of integration, the potential speeding up of strategic initiatives coming to fruition, etc. It is a complex process, but one that is critical for accurate assessment of the best way to achieve key business and strategic milestones.

How to Spend the Development Loot - the challenges of deploying capital externally

Once the development roadmap has been assessed, the ROIs crunched and the build vs. buy decisions made, what is all this going to cost and how are we going to implement our spending plans? Assuming we're not spending more than our cash on hand less the optimal cash balance, it's time to deploy. Funding internal initiatives are easy - it is the core of what Apple does and has done extremely well for a long time (at least during the Jobs days). It is how to make investments externally - either by seeding or buying small companies and/or technologies - that is complicated.

Why is this? Why not just set up an internal VC, just as Arik has suggested and what so many technology companies have done? Why is this even controversial? I'll give you four reasons off the top of my head.

• You are creating a completely new culture within the firm.

This is a huge issue. It is akin to creating an in-house prop trading desk inside a Wall Street firm. Every sell-side trader wants to get into prop trading, and the best ones often are given the chance to move to the other side of the Wall. This creates a "we/they," stratified culture that may be ok for a broker/dealer but is less so for a collegial, team-driven tech culture dependent upon teamwork and collaboration. Needless to say, Sales & Trading on Wall Street is not this way. Is it really worth the potentially adverse effect on culture to set up such an "elite" unit? I'm not so sure.

• Are you going to have deals assessed on a cold-nosed, arms-length basis absent of potential synergies, or are you only going to look at deals where there is strategic relevance?

This is a big risk. Remember the 1999/2000 days. EVERY TMT (technology/media/telecom) company had their own investment arm - Dell, Microsoft, Intel, Comcast, etc. etc. etc. EVERY one out-of-the-box said "We only do investments where there is a strategic rationale." Truth: bullshit. People got giddy. Investments were all over the map. For most the story didn't end well. Intel Capital is still a behemoth, Comcast Interactive Capital strayed a bit but has returned to its roots, but most others are on the scrap heap. For this to work a VC arm needs to be incredibly disciplined - but the temptation to stray is often great.

• Are members of the VC team going to be compensated like VCs or like Company business development employees?

See the first bullet above. If you want an true in-house VC, then by not paying VC-type compensation what are you really saying? You are begging for adverse selection. What VC-quality dealmaker is going to join a corporate VC arm to get paid salary + bonus? It just ain't gonna happen. So if you are going to pay VC-type money (carry, etc.), then you are going to get the business development brain-drain, as the best and most talented folks are going to clamor for being in the VC arm, and if they don't get their way, sayonara. And they would have been perfectly happy doing their bus dev thing, until that darned VC arm reared its juicy head. You've got to be very, very careful managing the politics and cultural issues around setting up such a venture. Be afraid - very afraid.

• Is the presence of the VC activity going to cause analysts to get distracted, and possibly confused, by performance?

This was classic back in the go-go days. I remember some of the corporate VC shops, after the value of the portfolios went parabolic in 2000, saying to analysts, "Sure, that $250 million this quarter is replicable. We expect that quarter after quarter. That should be considered part of Operating Earnings." I kid you not. Check the call transcripts. Unbelievable stuff. Of course when the sh*t hit the fan the next year, those same corporate titans were saying "Oh, that, those are just passive investment losses. Those have nothing to do with ongoing operations." Right. Whatever suits your purpose at the time, I guess. Bottom line: it is yet another element of possible confusion, something in this world that a growth company should try and avoid at all costs.

So while creating an in-house VC arm is certainly seductive, it is not without its risks and challenges. And these are not to be taken lightly - whenever you are gambling with company culture, DON'T MESS AROUND.

Spending the Residual - corporate finance policies on stage

Punch line: if there is money left over after partitioning the optimal cash reserve and funding internal and external business development, one can consider either hiking the dividend or implementing an opportunistic stock buyback. The decision should largely rest on the anticipated sustainability of the excess cash - if there is a high probability that the excess is likely to be regenerated on a long-term basis, then a fundamental change in dividend policy might be warranted. However, if one is less sure about the persistence of this excess, then a stock buyback is likely more appropriate.

Conclusion

Apple is a great company that has worked hard to build an enviable cash position. But before it goes off and spends material sums, it really should take the time to consider how much it should keep around and how to best deploy the balance. Because the potential benefits and consequences of a wrong decision are significant, to say the least. I'm sure Steve and Co. will do the right thing. Steve understands the value of culture - and culture is KING.

Comments

[Andy Swan]

Let the investors that invested in Apple get a return on their investment without selling their investment....i.e. a dividend.

Then they can invest the money themselves instead of using a computer/phone/gadget/software company to do it for them. :)

[Yaser Anwar]

Sir-

I'm not going to question your experience and expertise, but somehow I still think AAPL will be able to pull it off.

Howard- While I'm not a long-term shareholder of AAPL, I don't think they would be to happy to get 90% of the cash back. After all there are tons of things AAPL can do with, such as investing in R&D, making acquisitions, and give some of it to employees and shareholders.

Let's see what happens. AAPL has been range bound, 84-88 for about three weeks now, I wonder if today's not-so-great retail #s will affect 'em, guess we'll find out on April 25th reporting day.

[Roger]

Yaser, your comment, though interesting, misses the point. So Steve Jobs can build good, innovative, stand-alone companies. Great. This is why people own Apple stock. This says nothing about the cultural challenges of building an in-house VC. The value in NeXT and Pixar were created as stand-alone, separate entities. This did not involve the cultural issues and risks associated with building an in-house VC.

Further, the Wall Street analogy I referenced is a bad one for tech companies, because building a strong, positive, functional culture in a tech company is a delicate dance quite unlike that on Wall Street. The prop traders and sell-side traders can functionally operate under one firm, even if they hate each other, without adversely impacting the other. This is not the case in a tech company, and especially in a place like Apple, where functions - hardware, software, marketing and product management - need to work together as a seamless, unified whole. This criterion does not need to exist for prop and sell-side traders to do their jobs well. Ergo, the comparison is a poor one.

Investors in Apple are getting the benefit of Job's vision and business development expertise, and they don't need an in-house VC to do it. iPod, iTunes, MacBook, iPhone, Apple TV, etc. etc. etc. You've got to consider the risks and the benefits, Yaser, and from an analytical and cultural standpoint calculate the expected values and range of potential outcomes. It is the only way to do it.

Thanks as always for your thoughtful and provactive comments.

Roger

[howard]

give 90 percent to shareholders and refocus

[Yaser Anwar]

While you've mentioned some excellent points that should be on Apple's Cash To-do list, you missed out on a major point too.

What about Steve Jobs' track record?

Steve started Apple, which ignited the PC revolution with "insanely great" products such as the Apple II.

Took the company public in 1980 and in 1984 reinvented the personal computer with the Macintosh.

Then he was forced out, so he made NeXT Software. Again, Steve founded NeXT Software, which created really cool hardware that exploited the full potential of Object Oriented technologies.

NeXT technologies made programmers and users lives a lot easier. Then sold it to AAPL. Time to move on, again.

Pixar- discovered a little animation company that needed a vision. Liked the product so much that he bought the company. Pixar is now "the" digital animation studio (hits such as Cars, Toy Story etc). Sold to Disney last year and made a killing for shareholders and himself.

Why this trip down memory lane? Simple. There are a very few visionaries like Steve Jobs who've amassed an excellent track record. Why not put it to AAPL's use?

You pointed out Prop desks in-house for Wall St. firms being sort of a culture clash. Sure, but it has worked out right? So why can't AAPL do the same?

I agree AAPL should dot the Is and Ts make sure its got enough working capital and then some cash left, but then start a small in-house VC. The great culture and talent pool at AAPL, I can see AAPL coming up with a few more out-of-the box innovations.

Also, there is a lot Steve can pass down to his employees in terms of creating disruptive and innovative technologies. So when he's gone, his spirit and teachings allow AAPL employees to do what he does so best- innovate and bring vision to life.