BY KENT SHAW, CFA
Large successful companies have opportunities that smaller companies do not. A lengthy period of success raises the stature of a company within the capital markets and often within society. Such elevation can be exploited in a way that their customers and shareholders may not see. One such phenomenon is the enviable cash management of Apple, the mammoth maker and inventor of the smartphone. Building one of the largest companies in the world is impressive in itself, but what is also impressive is how Apple has been able to utilize their strength to create a cash management strategy for the company utilizing their advantage in credit and tax rates. Let’s review further.
Please keep in mind that this discussion is for illustration purposes only. It is not a recommendation of Apple’s stock but rather a commentary on the quality of the company. High quality companies can be great investments but that isn’t always the case. Understanding a company’s valuation is also very important and we offer no discussion of that here.
As of July, 2017, the company had $261 billion in cash and investments on its balance sheet. Of this amount, roughly $246 billion is held with its subsidiaries outside the US where it can’t be taxed by the U.S. tax authorities. Many articles have been written about the stash of cash at Apple and other multi-national corporations that would be taxed at roughly 40% if it were brought back to the US. Rather than walk through all of those examples and arguing strongly for tax reform, let me just ask a hypothetical question: would you rather have 20% of $261 billion or 40% of zero? I’ll pause while members of Congress reach for their calculators to solve the problem.
Now, on to something more interesting that hasn’t been discussed much – “free money”. Free money? Well, in a manner of speaking it’s almost like free money. Of the $261 billion held by Apple, roughly $184 billion is in long-term bonds. Based on disclosure from the company in 2016, the majority of these securities are corporate bonds (bonds issued by other companies). That’s not so strange is it? Investing your money wisely should be expected. But why does Apple also have $97 billion in debt?
Apple’s business is revered because everyone loves using their phones and investors like owning their bonds. This love affair allows the company to issue debt (i.e. borrow money) at a surprisingly low rate. Of the 500 largest publicly traded companies in the United States, only two have higher credit quality than Apple, as rated by Standard and Poor’s. For some time now, the company has been taking advantage of this fact by borrowing at a below average rate and then investing in corporate bonds with the proceeds.
The average company of this group of 500 has debt that matures in 10 years yielding 3.82% while Apple is able to borrow money for the same period at 3.00%. Some of the money Apple has generated from issuing bonds (i.e. borrowing) is likely used in the US to operate its business while we suspect some is held outside the US and is invested at a higher rate in corporate bonds yielding more. We cannot know the exact yield earned on Apple’s bond holdings so we’ll use an estimate based on the average company of the group. If we assume only 10-year bonds are held, which is unlikely, then Apple is effectively borrowing money at 3.00% and investing at 3.82% for a benefit of 0.82%. That hardly seems worth it. But wait, there’s more! Taxes must be paid on those earnings.… sort of. The bonds Apple issued are in the US where Apple’s combined federal and state tax rate is 44%. Since interest expense is tax deductible in the U.S. this effectively reduces the cost of that debt by the 44% tax rate. Nice! Then Apple has the opportunity to record most of the yield from their purchased bonds in Ireland where they get the benefit of a 12.5% tax rate on the earnings. Do you see where this is going? They are able to win on both sides of the pond.
Below we have calculated an estimate of the after tax return.
After tax cost of borrowing for Apple: 3.00% X ( 1- 44% tax rate) = 1.68%
After tax yield outside the US: 3.82% X ( 1 – 12.5% tax rate) = 3.34%
Based on our estimate, after taxes, Apple is effectively borrowing at 1.68% and then investing at least some of those proceeds at 3.34% at relatively low risk. That’s not quite free money but it’s not a bad deal for a bank. That also makes smartphones.
The information provided is for illustration purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action to be taken. These analyses have been produced using data provided by third parties and/or public sources. While the information is believed to be reliable, its accuracy cannot be guaranteed.