Does Apple Have A Safety Net?

Apple's recent plummet below $100 a share raises legitimate questions about just how low Apple can go -- and the prices at which it is particularly attractive.

Cash: Show Me The Money
The last time I did the math on Apple's cash and short-term investments positions, it was something approaching $24/sh. ShortSqueeze says Apple has 885,875,706 shares outstanding; as of the end of the quarter ended June 28, 2008, Apple reported:

• $9.373B cash/equivalents,
• $11.401B short-term investments, and
• $1.559B in current receivables (net of allowances).

To avoid inadvertent overstatement, let's pretend Apple's collects none of the current receivables, and conclude the approximate war chest of current liquid assets is $20.774B, or $23.45/sh. This number is likely higher by this point in the subsequent quarter, as Apple's been very cash positive for a while: Apple has probably been collecting receivables and completing and collecting on new sales. Apple has other current assets, a bit less liquid, such as tax assets and inventories, totaling over $27 billion, and its current liabilities (accounts payable and accrued expenses) approximate its cash equivalents.

Current assets are assets that are expected to be turned into cash within a year. Apple also has real estate, buildings, data centers (these hard assets are carried at $2.117 billion), and other things that are not expected to turn into cash within a year. I tend to assume "goodwill" and intangible assets are useless in liquidation and ignore it when valuing emergency/worst-case valuation scenarios, but Apple's intellectual property -- which includes its desktop and embedded operating system software, its application software, its brands, and its online store -- is certainly not without value. The current assets plus the property, plant, and equipment (and excluding goodwill and other intangibles) total about $30 billion, or $33.86 per share. Mind you, the book value of long-owned real estate might be quite different than market value; but Apple isn't Sears, and doesn't own that much real estate. Apple stores sit on leased properties, for example.

Since Apple is profitable and solvent, one would not expect shares to be rationally priced below liquidation value. One might expect the shares to trade for something akin to the present value of the company's cash flows, or the discounted future earnings plus cash, or the like -- and all of these yield a number greater than cash on hand.

Valuing Apple is complicated by the fact Apple doesn't recognize all payments as revenue on receipt, but uses subscription accounting for iPhones and certain other products. Whether there's a "liability" booked someplace to prevent cash receipt from being recognized as revenue on receipt won't change the cash number any; the cash shouldn't be higher just because some of the cash will be recognized as revenue later. This just changes the timing of the taxation on the cash. Since Apple's not doing much of value with the cash that I can tell, I don't see how delaying taxes a little gives shareholders much benefit. I suppose it's one of those things you do on principle because it sounded cool in B-school.

Cash: Easy Come, Easy Go
Sometimes you read about management diluting shareholders with a new options issuance now that the price is in the toilet. Angry suspicion, based on a low view of the quality of management's commitment to shareholders, is justifiable in Apple and many other shareholder-hostile companies. Cash per fully diluted share is something we might want to keep in mind if making worst-case predictions about Apple, but become aware of an options grab. If we know how many options have been issued, we can assume they all get exercised, add them to the denominator, and see how it changes cash per share.

Dilution by 10,000,000 shares reduces cash per share to $23.19/sh.

A $10B share buyback at $100/sh, by contrast, retires 100,000,000 shares (while it also "retires" $10B), moving cash per share from $23.45/sh to $13.71/sh. This is a dramatic reduction in cash, much greater than the hypothetical 10m share grant, but it has an upside: one hundred million fewer shares means more revenue per share, and more positive cash per share in the future. The per-share metric boost would amount to something like a 11% increase.

The 11% increase in per-share metrics doesn't mean the money produces a 11% return; it is a factor magnifying whatever return Apple produces. If Apple's return is lame, the amplified return will be lame+11%, which will be lame indeed. If, however, Apple moves from this economic downturn with the ferocity with which it departed the last one, Apple's return may be extremely strong -- and the 11% increase in that return could be extremely valuable.

But It's Going To Get Worse
Assuming the economy worsens, and confidence in Apple plummets because it is viewed as a vendor of unnecessary fashion luxuries, Apple may have an opportunity to repurchase shares at a price materially better than $100 per share. If so, Apple's amplified returns would be better because it would retire more shares for the same money.

Considering that the market is in an utter panic, and that Warren Buffett stated (in a recent interview with Charlie Rose) that he'd never seen economic sentiment so fearful, and that he anticipated a best case scenario involving six more months before a turnaround even began, it seems Apple -- regardless the performance it demonstrates -- may see its share price battered into insane territory as liquidity-squeezed investors are forced to dump anything of value to de-lever in the face of declining equity values. Apple might do well to think of a repurchase plan after the November election persuades skittish investors that capital gains tax reductions will be allowed to expire, reducing the value of equities by reducing the value of their (post-tax) returns and causing people to dump to take profits while the expiring capital gains rates persist (which may also create a liquidity problem, and a short fest).

There are some interesting things to think about here in terms of the possibility of a shareholder-value-enhancing buyback at irrationally low prices, but they are academic: Apple's shareholder-hostile management would never use cash to do something that benefits only shareholders, like repurchase stock. Apple's management routinely does things that benefit shareholders incidentally, like sell high-margin computers and seize share in the highest-margin segment of the mobile phone market, but these things benefit Apple an an entity and are not directed at shareholders. Retiring shares does nothing for Apple as an entity, but only serves to increase the fractional ownership of non-selling shareholders.

Where Apple Is Going
Apple's liquid assets are about $24 a share and will increase with time due to Apple's free cash flow. This places a floor on the rational price of Apple, but not on the actual price of Apple. The price will be worth watching, as will Apple's performance -- in absolute numbers (units), and in comparison to competitors (share). What Apple does during the downturn will determine its pole position as the economy heats up again eventually. (Perhaps, for example, Apple might invest in new production facilities to obtain future advantages in margins, production characteristics, and pre-launch secrecy.)

However, Apple's cash doesn't really help investors in the short run: Apple isn't paying it to shareholders, Apple isn't using it to retire shares, and Apple hasn't shown any talent for earning money from it. Apple's near-term share price will likely be driven not by factors internal to Apple (like the quality of its execution) but by external factors like sentiment, liquidity, and panic. Comparing Apple's performance to the price movements may create some opportunity for contrarian entry theses, and may give rise to some good buy opportunities.

The Future Is Not The Past
Apple's miraculous movement from 1997 to the present involved a movement from non-profitability to profitability. Margins improved by an order of magnitude. These are changes that can't happen twice.

That said, the future is different in positive ways, as well. Apple is now a major player in entertainment content distribution. Apple is no longer dependent -- largely due to the advances of web standards -- on Microsoft-produced browsers for its customers' access to the connected world. Apple sells integrated solutions for creative content production and plausibly will continue to add high-margin software offerings to its portfolio of customer offerings. Apple is experimenting with the enterprise market (iPhones, ActiveSync, and MobileMe) and has greatly expanded the range of customers interested in buying Apple products (music listeners, phone users, game players). Retail stores allow Apple to reach customers that previously never saw Apple products demonstrated in a positive light, and the stores are both profitable and increasingly globally visible.

The next ten years won't be the last ten years. They will, however, involve competition against some of the same players -- players Apple has apparently mastered fighting. They will be ten years of new hardware, new markets, and increasing price per unit of performance of component parts. Apple's addressable market will grow, and with it Apple's opportunities to reach out with sales opportunities.

If Apple's price becomes really crazy this suggests an excellent long-term buy. The question is: at what price have the shares become crazy enough?

On the other hand, in this fearful market and facing the liquidity concerns that it poses, there is no safe price for someone unable to tolerate short-term price collapses. The opportunities presented by this market are most attractive, I believe, to solvent investors who will remain without a need to liquidate positions for the foreseeable future.

Comments welcome :-)