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March 7, 2007

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 formationlast 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 initiative 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 Hulbertpiece 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.

********************

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.

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