Original URL: http://www.theregister.co.uk/2013/03/25/apple_cash_pile/

Apple share-price-off-a-cliff: Told you that would happen

Don't tell Oracle, but you can be too rich and too thin

By Dominic Connor

Posted in Financial News, 25th March 2013 12:25 GMT

I was allowed to write this piece because in November I wrote to our glorious editor after a London Quant's Group seminar to say that the price of Apple shares would tank sooner rather than later.

As you all know, that’s just what happened - from just shy of $800 to the mid $400s. The reason I don’t make all that much money out of that is the economics were inevitable but the timing was viciously hard to call.

The Free Cash Problem

It tells you something about economists that this is what it’s called.

Both history and game theory tell us that cash piles will inevitably be squandered, often doing more harm than good. But if the Powerpoints that senior people at your firm confuse with actually managing are saying “We can do more with less”, you’ll be rightly sceptical of the idea that more money will make you less efficient.

Imagine for a second that Apple is the best tech firm on the planet. Certainly that is what some people tell me. Why would you think that is good for the share price ?

It’s no secret that fondleslabs are selling well and by the time you read this the wrist Jobs may be on offer. Shares only outperform the market if there’s good news, not olds. The share price reflects the expectations of future earnings and so being the best is not good enough when you come to deal with the dangers of success.

Money is a harsh Mistress

As an IT pro you have to make hard decisions like getting a new UPS that is actually uninterruptible this time, or an extra server to cope with traffic. I don’t know what’s better for you and I doubt you do either, at least not with 100 per cent accuracy, but you will try to make the best call and unless you work for Capita I have confidence that you will usually be right.

You can put all your options into an ordered list with paying the power bill at the top and buying me beer at the bottom. Once you get past the things you must do else the business stops, you get into a mix of what you need to do and what you’d like to do.

We’re alone here, so you can be honest with me. That huge Apple monitor you have doesn’t really up your productivity does it? This is captured in the most openly cynical academic subject, “Agency Theory”, AKA the difference between what you pay people to do and what they actually do in response to their incentives.

So as you move down the ordered list you inevitably get less bang for your buck as necessary spending evolves into good spending into nice to haves and ultimately “we’ve got to spend X by the end of the year else our budget will be cut next year.”

You could act for the good of the firm by saying “we don’t need more cash”. But in 30 years of IT I have never seen this happen. Have you?

The inevitable fact is that giving you more and more money compels you to make worse decisions and this is the important bit. No matter how good you are at deciding, more money makes your decisions dumber.

Freed of the discipline of paying urgent bills, you don’t just pocket the spare cash (usually), but it’s easier in your own mind to justify things that are sort-of useful like those really cool biometric eye scanners for the comms room or an off-site team meeting in a nice hotel with spa and reassuringly expensive bar.

This effect scales all the way to the event horizon. Exactly why does Apple or Oracle need a high status HQ building? Yes you get better staff if the working conditions are nice, but ultimately you look out of your office window, so the beauteous HQ is for the benefit of others.

Of course Apple has so much cash that a few hundred megabucks on offices won’t come close to breaking them, but a few hundred meg here, a few there and pretty soon you’re talking about real money.

Managing the Cash Pile

You probably know that the Macintosh was named after the kind of Apple, not the coat, so it follows that the hedge fund that handles a large chunk of Apple's cash is called Braeburn. Nor should it really surprise you that its performance relative to the market is rather less than stellar. As any Quant will tell you, the only consistent performance of fund managers is under-performance, a fact borne out by a lot of research as well as personal experience.

Until it peaked, the share price of Apple meant that almost any other investment would have a lower return so cash actually acts as a drag. So unless you believe that Apple has an unlimited number of high return investments the return as a percentage of the assets must go down as the cash pile increases.

Of course you can get more investment returns by taking on more risk. For instance at the start of the year those nice safe banks in Cyprus were offering good returns, however just like in Iceland that did not turn out well and that's before we enter the choppy waters of Madoff-scale scams which conned high end professionals as well as ordinary decent folk.

Oh, it's for R&D, is it?

Apple says it needs money for the R&D because it is a hi tech firm. Certainly it spends some money that way, but we have to ask what they are planning with that 140 billion or so?

NASA reckons that going back to the Moon is only about 50 Gigabucks and the Large Hadron Collider is a pathetic 4 billion. Meanwhile the market capitalisation of ARM - who are behind the chips that power the iPhone, iPad and most of the other tablets and phones in the world - is about $18.2 billion, so they could buy them.

What about mergers?

For the same pay, would you rather be the CEO of a $1bn niche company or a $3bn conglomerate ?

That’s not even a hard question.

Also of course the bigger your firm, the bigger your pay so both your ego and your wallet swell through mergers. Larry Ellison is a very smart manager and so committed to the interests of his shareholders that I'm sure that one day, maybe even in our lifetimes, the Sun acquisition may pay off.

Oracle had loads of money, it still is hardly poor, but if it were led by a someone of less stature than Mr Ellison a person more cynical than me would think that the merger was driven solely by a desire to overtake Carlos Slim as the richest man in the world. It's also obviously only a coincidence that Oracle sponsors big yachts which are an interest of Mr Ellison's.

The point of a merger is that you pay more money for it than the people who currently own and run it think it's worth, because otherwise why would they sell it?

Although Apple could buy ARM, that might well damage this stupidly successful British chipmonger. ARM has good relationships with all the smartphone makers because it is a supplier not a competitor. Would you want to share your product plans with Apple?

Also ARM may screw up one day and produce a third-rate chipset. If they're an external supplier you just pitch up to Intel or nVidia, but if they're in the family you end up having to use their stuff whether it is good or not.

The current newsworthy failed takeover is Autonomy. There are all sorts of accusations and spin, but some objective facts are clear. HP put a big pile of cash in the hands of Autonomy shareholders at a price that many commentators at the time said was too high. I don't know what allegedly creative accounting did or did not occur, but if I paid hundreds of millions to the board of HP, I'd expect them to be very hard to swindle. (And don't forget Meg Whitman was on the board that OK'd it.) Maybe they just made a bad judgment. Either, both, shareholders don't care. The money is gone, but it supports the point about too much cash lowering your business IQ.

Mergers are like evolution, good for the species as a whole but bad news for the individuals being evolved out.

Status

Why do some firms have such glorious buildings like Apple? Infinite Loop no less. As I said earlier, having a nice office helps you attract and retain good staff, but that wears off pretty quickly. The fact is that it makes senior management feel good. Have you ever bought an IBM xServer because Hursley Park has nice sunken gardens? Do you even know (or care) what Microsoft HQ looks like? It makes sense for Apple Stores to be works of art, but the HQ? As an IT pro, what would motivate you more, $5k if you reach your next objective - or a handwoven office carpet?

This isn't just corporate excess. Civil servants who are wage-capped sometimes work in places that are legally defined as palaces. There are enough tall stone columns on government buildings to give a Freudian psychologist wet dreams, because people will always find a way of trying to extract what they "should" be paid even if it's just taking home Post-Its.

The Apple HQ isn't a big percentage of the cash pile, but architects are smart people, they are domain experts in sounding positive about the stupid design requests from CEOs who know everything about marketing technology to punters and think that carries over to making a great office building. It is a huge distraction, especially when you remember that board members cost up to $1m per day and a decent architect that they are "helping" is $300k per year.

Greed is Good

If you wanted to invest your money in a hedge fund like Braeburn, why would you not do so ?

Or invest in a firm that you feel has better growth prospects?

This is where Agency comes back in again. As an Apple shareholder, the cash is yours but almost no management team in the world sees it that way.

They see it as a set of options for them to exercise for the good of the firm and/or themselves. That's why activist shareholder David Einhorn is suing the company that he owns a chunk of. He knows the stuff I've written and a whole lot more and wants Apple to issue a big dividend that leaves them enough cash to continue being powerful, but not so much as to make them squander it on prestige offices and takeovers that destroy value. Lest I sound like an Einhorn fanboi, he would of course make a great big wad of cash out of this as would the people who've invested in Greenlight Capital, so it's not quite an act of charity.

Predicting the Apple Share Price

It is now the case that everything I've told you is now captured in the price of Apple stock, so has very little predictive power. It does however reflect the inherent vulnerability of Apple as a firm. The iWatch may fly or not, but few very large firms are as pathetically dependent upon a small number of products as Apple. MS and IBM may have smaller market values, but they have a much wider portfolio of products and services which is why Vista was only a relatively small dent in MS and why being kicked out of the PC business actually worked to IBM's advantage.

Apple is thus going to be forced into more “bet the company” launches. It can easily survive an iWatch failure, but to deliver high percentage growth it will need to bet a high percentage of the firm. ®

Dominic Connor is a financial headhunter who gets told all sorts of things about financial markets, some of which are even true.