Monday, December 06, 2010

Memo to Steve Jobs: “It’s Warm Inside the Herd”


“It is warm inside the herd…but then, of course, you go off the cliff.”
—Jean-Marie Eveillard, First Eagle Funds

What the heck: we’ve written an open letter to Ben Bernanke, the most powerful central banker in the world, so why not write a memo to the most powerful CEO in America?

The genesis of today’s virtual memo is the recent spate of articles in financial publications revolving around the topic of what Mr. Jobs’ company—Apple—ought to do with the growing cash hoard on which that company now sits.

The articles stem from the fact that everybody outside the actual company that created the cash hoard has an opinion on what to do with that cash. And what everyone is recommending is this: Apple should spend the cash—and sooner rather than later.

Here’s how a recent Bloomberg story led off the discussion:

Apple Piggybank Earns 0.75% Return as Investors Ask for Payback

Apple Inc.’s piggybank, stuffed with $51 billion in cash and investments, is earning a lower return than a typical U.S. savings account. Some investors say Steve Jobs should put that money to better use….

Apple got a 0.75 percent return on the investments in the past fiscal year, according to a regulatory filing last week. The gain pales next to the roughly 10 percent investors would have earned from the Standard & Poor’s 500 Index and the Dow Jones Industrial Average over that time. Apple’s stock itself also was a much better investment, rising 60 percent….

—Adam Satariano, Bloomberg, 11/2/10.

For the record, the cash hoard that seems to be burning a hole through the pockets of everyone except the folks at Apple is mainly the result of two facts, both of which have nothing to do with the outside observers now indignantly calling for it to be put to ‘better’ use:

Fact One is the outsourced manufacturing model Apple began implementing a decade or so ago when the first iPod was launched. Under the careful watch of Fred Anderson, the CFO at the time, Apple abandoned the asset-intensive, factory-owning high-tech business model common to Silicon Valley, farmed out production to low-cost Asian companies, and so began turning inventory into cash in a way that forever changed the way Silicon Valley looked at where value was really added.

Fact Two is the success of those products themselves, starting with the lowly iPod—a mere music player that morphed into the all-purpose “internet in your pocket” iPhone, which itself begat the notebook-threatening iPad, whose “instant on” capability is something Intel hoped to do with PCs for at least a decade and never got close.

Combined, those two facts have created a business model from Nirvana that requires none of Apple’s capital dollars—none—to be tied up in chips, circuit boards and manufacturing lines, thus allowing Apple to generate gross profit margins that are half-again higher than commodity box builders such as Dell and HP, and gross profit dollars that don’t need to be plowed back into plant and equipment.

Instead, they can be plowed into R&D, sales and marketing, with the leftovers sent to the bank.

So successful is this model that Apple, as has been widely noted, now finds itself with the aforementioned $51 billion worth of leftover cash sitting in the bank.

And that $51 billion, as those same articles point out, is earning almost nothing, thanks to Apple’s conservative investment policy and the low interest rate environment of the moment.

Here’s how the Bloomberg story continued the critique:

For some shareholders, the cash hoard is overkill, especially considering Apple added about $17 billion to its balance sheet last year, though they don’t want a big, overpriced acquisition either.

“That amount of cash is way above what’s needed to have a prudent war chest,” said Keith Goddard, CEO of Tulsa, Oklahoma-based Capital Advisors Inc., which has $822 million under management, including Apple shares. “It would be a real shame for them to do an acquisition to get into another line of business or dilute something they already have going on.”


Now, it is true Apple’s cash return of 0.75% has significantly lagged the broad stock market, and Apple’s own shares, in the last twelve months.

It is also true, however, that Apple’s cash earned significantly more than the stock market, and Apple’s own shares, in calendar 2008, when all those years of Americans living dangerously came home to roost, and investors sweated out a 37% market decline and a near-death experience for the world’s financial system.

Have those investors already forgotten about 2008 and early 2009?

Did the “Flash-Crash” never happen last spring?

Will there never be another Asian crisis, as in 1997-8? Another Internet Bubble, as in 2000? Another “Black Monday”…or “Black Tuesday,” for that matter?

Indeed, we suspect that Apple investors—including, we would bet, all those quoted to the effect that Apple’s $51 billion cash hoard violates some sort of hidden magic cash figure learned in Financial Analysis 101—took immense comfort in the company’s $25 billion September 2008 cash cushion during the panic-stricken days of 2008 and early 2009, when Apple’s market capitalization plummeted to under $100 billion and investors around the world were wondering whether anyone would have enough money to cough up lunch money, let alone enough cash for an iPod or iPhone.

More to the point, we also suspect that some of those same voices also once applauded similar “return value to shareholders” exercises that other companies pursued to their ultimate detriment.

Exhibit A in this category is Dean Foods, purveyor of milk and other dairy-related products, which in early 2007—that’s three and a half short years ago—decided to “return value to shareholders” by paying a whopping big dividend to shareholders.

Now, Dean Foods didn’t have the balance sheet Apple does, but that didn’t stop the company from listening to the siren song of its investment bankers and other “return value to shareholders” mavens.

Here’s how the company justified its actions on a conference call with Wall Street’s Finest:

We announced this morning that we will return approximately $2 billion in capital to our shareholders through a special dividend of $15.00 per share. Before Jack walks you through the details of the recap and the dividend, I would like to discuss with you the factors that make this transaction the right step for Dean Foods' shareholders at this time.

Given our internal focus, our strong cash flows, and the incredible liquidity and flexibility of today's debt capital markets, the appropriate finance decision for Dean Foods today is to increase our utilization of the debt markets and return equity capital to our shareholders. We believe we can do so without diminishing our capacity to grow or foregoing appropriately-priced, strategically-sound acquisitions. Our robust growing cash flow should allow us to de-lever our balance sheet over the next few years….

But clearly from our perspective it was an opportunity that it would have been, in our view, a significant mistake in judgment not to take advantage of the markets that present themselves today. These are extraordinarily liquid markets; they are extraordinarily flexible; and they're extraordinarily well priced.

—Gregg Engles, Dean Foods Chairman and CEO, March 2, 2007


Readers can imagine the huzzahs such a “shareholder-friendly” announcement generated at the time—and, indeed, the analyst from Bear Stearns said “Congratulations…obviously a good announcement” on the triumphant conference call.

(We will pause while readers digest the irony of an analyst with a firm that didn’t survive the financial crisis congratulating a company in a low-margin, highly cyclical business leveraging up just months before the crisis hit.)

Alas, Dean Foods’ shareholders are nowadays wondering all what the congratulations were about. The 'significant mistake in judgment' turned out to be the dividend itself. Dean Foods' balance sheet has not been de-levered since that balance-sheet-destroying event, and the shares, which closed at $34.50 that day ($19.50 adjusted for the $15 a share dividend), traded at $8.50 the day after the company announced yet another in a string of disappointing earnings reports last month.

Oh, and the “Jack,” the Dean Foods CFO referenced by Mr. Engles in the 2007 call touting the special dividend has resigned.


All that said, what, you might wonder, does Steve Jobs say about Apple’s cash?

Again, from Bloomberg:

Jobs, Apple’s chief executive officer, said last month that the company has a good track record of using cash, saying it’s holding money for one or more “strategic opportunities,” rather than a dividend or stock buyback.

Indeed, Steve Jobs and the Apple management team do have a good track record of using cash, if the iPod, the iPhone and the iPad are any indication of what they have been doing with it.

So why not let them worry about the cash hoard?

And if, for some bizarre reason, Steve Jobs ever feels himself moved by the writings of various individuals who have never met payroll, let alone created a product like the iPhone that literally changed lives, to blow all that cash on some special dividend or massive share buyback or some otherwise cash-dispensing activity euphemistically labeled “shareholder-friendly,” we would urge him and his board to consider the examples of other company CEOs who have likewise been so moved.

It is, indeed, as investment genius Jean-Marie Eveillard warned a group of students at a recent San Francisco State FAME investment conference, “warm inside the herd.”

But that is cold comfort when, as he said, the herd goes off the cliff.


Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

11 comments:

CTA said...

Bonus points for the person that identifies Jack's new employer.

Kevin said...

First, haven't shareholders already been paid for this cash? If stock prices really are forward looking, then the excess cash sitting in the bank shouldn't be all that consequential - and really should be managed conservatively (i.e., not used to enrich management or otherwise wasted). But more importantly, isn't the reason for paying a premium for this stock (to the extent there is one -- today, you'd pay roughly 17 times 2011 consensus) that you think the business has better than average growth potential? Doesn't that implicitly mean you'd rather have Steve Jobs invest the cash than give it back to you? I can understand returning cash in a utility-like business (low growth, stable cash flows), but for a tech company, it seems the exact opposite of what you'd want.

Anonymous said...

I suppose the same "it's warm inside the herd" quip could be applied to the hordes of growth managers who now own AAPL at a 6% average weight.

I'm well aware that you are more in the business of dispensing investment advice than receiving it, but one should be careful not to forget that the shareholders own the company (and the cash), the Board represents their interests, and management is hired by the board. Just remember you own a business, not a piece of paper. As an owner, it is perfectly reasonable to want to take cash out of the business.

Anonymous said...

Jeff, while your posts on cash management were excellent in the last business cycle, they are contributing to our current economic problem, i.e., every company is hoarding cash on your advice. Businesses need to spend to get the economy going, but they are hoarding cash instead.

Regarding Apple, its business is throwing off excess cash at the moment. The real question is whether this is temporary. Assume Apple stays with the current business model, then there is no reason to believe that it is temporary. But let's face it, how could Jobs sleep well at night without hoarding as much cash knowing everybody who is somebody is trying to grab a piece of market share from iPhone and iPad? And this is really the key problem for Apple - its key products are in markets where the rate of innovation is too fast. i.e., we don't know what Apple will look like five years from now. It could be the most dominant tech company on earth, or it might be left in the dust by the competition. Thus, I think hoarding cash is a reflection of Jobs' insecurity about Apple's future.

Dan said...

Good post.

In addition, I believe Dean Foods did equity raises to pay down debt in 2008 and 2009. So shareholders got diluted to pay off the debt from their special dividend.

Buy high, sell low. Good work if you can get it.

Anonymous said...

What would be wrong with returning 10% of that cash hoard and declaring a $5 special dividend? That still leaves the company with $46 billion. Plenty of bullets in the chamber for strategic opportunities.

cadamyale said...

Kudos. One of your best pieces ever.

Anonymous said...

So is there ANY limit to the amount of cash you think it would be prudent to hold on the balance sheet, in Apple's case?

$100 billion? $200 billion? $500 billion?

Dan B said...

Excellent piece. How long will it take for business school professors to start talking about the option value of cash?

LifeAfterMBB said...

This is one great post!!!

I blame the herd mentality on modern corporate finance training at B-schools, where they have been drilled into them that capital structure can be "separated" from operating performance.

Anybody with real experience running a business would know that, with a big capital reserve, it'd much easier to negotiate better terms with suppliers, be able to work with the most capable suppliers, and have a much better chance winning new businesses.

Apple is in the business of creating new markets, and they have been extremely successful at it. Having such a large cash horde on hand, Apple keeps its options wide-open regarding which market to enter into next.

LifeAfterMBB said...

BTW, why is it that no one ever tell Warren Buffet to return money to shareholders?

Without his cash horde, he would not have been able to make a killing in GS, GE, etc.