Apple is Getting Paid to Raise Debt

Apple just raised $1.35 billion of Swiss-franc denominated debt in two tranches (0.28% and 0.74% implied yields), according to the WSJ. Apple is raising debt to fund its capital return program. In what can only be described as being at the right place at the right time, Apple is essentially getting paid to raise debt. 

Apple may enter currency swaps to effectively convert Swiss Franc-denominated notes to U.S. dollar-denominated debt, which would increase the effective "cost" of the debt. Even taking this cost into consideration, Apple is in a position to earn a small profit by issuing debt. By raising debt, Apple is able to use borrowed cash to buy back AAPL shares, thereby saving on dividend expense. All else equal, and assuming an estimated $13 million after tax currency swap cost, Apple would make a profit of $1 million by raising $1 billion of debt at a 0.28% interest rate, as depicted in the table below. 

Exhibit 1: How Apple Can Make a Profit by Raising Debt

Apple will have raised close to $40 billion after including today's debt issuance. It is important to recognize that the total amount of debt is spread out over various maturities ranging from 2 years to 30 years, depicted in Exhibit 2.

Exhibit 2: Apple's Long-Term Debt

By holding debt with a wide range of maturities, Apple isn't on the hook to repay the $40 billion at once. Instead, Apple will be able to use U.S. operating cash flow (or foreign cash in the event of U.S. corporate tax reform) to repay the debt as it comes due.

What is management's long-term strategy by raising debt? 

1. Use debt to fund share buyback for what management considers to be undervalued AAPL shares. 
2. Once AAPL shares are appropriately priced, slow the pace of buyback. 
3. With slower buyback, U.S. operating cash flow can be used to repay debt as it comes due. 
4. Repeat cycle with AAPL share valuation being the primary determining factor.

Management is utilizing proper capital allocation practices to not only take advantage of what they consider to be undervalued AAPL shares, but deal with excess cash weighing on Apple's cost of capital. Since $158 billion of foreign cash can not be used for share buyback or dividends, management is raising inexpensive debt as a substitute. Market observers look at this as a sign that management is confident in Apple's future and that the company won't likely require $100+ billion of cash for organic growth opportunities. 

There will be a day when raising debt isn't in Apple's (and shareholders') best interest, but that day isn't today. 

This report was produced by Neil Cybart on February 10, 2015 and is not meant to be used as investment advice. I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe. 

Thoughts on Apple's Employee Retention "Problem"

Bloomberg published a story late last week on how Tesla has been hiring Apple talent over the past few years and now has more than 150 former Apple employees on payroll. Anyone who has been tracking Tesla would be familiar with this issue considering that several current (and former) Tesla executives were former Apple employees. I think this issue says more about Tesla than it does Apple. Tesla CEO Elon Musk is a charismatic leader with a clear vision on rethinking the automobile and energy industries.  Who wouldn't want to be part of that type of project? 

The primary issue with roping Apple into this discussion and analyzing the company with a negative tone is that by doing so, one is comparing Apple's strategy and product roadmap to Tesla. The assumption is if 150 employees were willing to leave Apple to work at Tesla, then that must mean Apple was unable to retain talent with exciting ideas and projects. I disagree.

As we have seen over the years at Apple, there should be no expectation that talent responsible for bringing a collection of raw ideas into a finished product, such as the iPod or iPhone, will stay around until the next big thing is developed. Many people on these teams held positions and responsibilities focused on specific tasks. Instead of being shifted into another role these employees may join other companies that have their own "iPhone-like" project under development.  When I hear that an Apple employee left for another company, I often look at it as a positive for the company they are joining, not necessarily a negative for Apple.

The Apple employee retention debate boils down to two questions: 

Does Apple have an employee retention problem? I spent the past few days rethinking the question and concluded it may just be too loaded to answer completely. Apple's structure necessitates the need to continuously hire outside talent since Apple's mission is focused on coming up with new products. It is not reasonable to think that Apple's current employee base and skill set can fully realize Apple's mission without looking outside for help.  Accordingly, the much more important question may be does Apple have an employee acquisition problem?

Apple is a somewhat routine acquirer, often hiring teams of people, or at the minimum acquiring technology, and Apple is constantly searching for new people to fill talent holes. Some of Apple's recent high-profile hires include:

• Luca Maestri (CFO)
• Angela Ahrendts (SVP Retail)
• Kevin Lynch (VP Technology)
• Dr. Michael O'Reilly (VP Medical Technology)
• Paul Deneve (VP Special Projects)
• Ravi Narasimhan (R&D)
• Dr. Roy Raymann (R&D)
• Marc Newson (Industrial Design)

As seen with some of Apple's very high profile executive hires, does Apple have an employee acquisition problem?  Will most of these employees stay for the rest of their careers? Is that now a retention problem for Apple? I'm sure if Apple management had its way, some of the former Apple employees currently working at Tesla would still be at Apple. The Bloomberg piece mentioned that Apple had increased financial incentives to entice Tesla employees to join Apple. I wouldn't want to be so naive as to assume Apple management is able to retain everyone they want, but I just don't see employee retention as one of Apple's pressing issues given the company's product-centric model focused on new products in new disciplines.   

Is employee retention a risk factor for Apple? Yes. Employee retention is a risk factor for any company. The mistake that I see many people make is equating "risk" with "problem." Just because something is a risk factor, there is no claim being made that it is currently a problem. In addition, employee acquisition is just as big of a risk factor for Apple, if not bigger, than employee retention.

The primary pushback I have received on this subject is that Apple's success is not dependent on high level executive hires but software engineers, and recent "issues" with Apple software and services is a sign that Apple is indeed having issues retaining this talent. It is no secret that Apple is lacking in resources, with engineering talent being one example, but there is simply not enough evidence to suggest that employee retention is the culprit of recent software "issues." Rather, Apple's focus on acquiring the next marginal customer and the corresponding pressure to ship new and exciting software features at a increasingly fast pace has produced tradeoffs with software quality taking the brunt of the fallout. I'm not convinced that having more chefs in the kitchen would necessary change the outcome. 

Ultimately, a properly functioning Apple organizational structure and business model will appeal to the best and the brightest. Judging from some of Apple's recent hires, this is still the case. Once Apple ships a product and resources shift to the next big thing, a certain level of turnover should be expected within Apple ranks as materials and resources are reallocated. Finding the people needed to turn ideas into reality is Apple's biggest risk factor. Apple is expanding into new areas in which company resources had historically been underemphasized such as health, wearables, and content discovery and curation. Apple has made progress in terms of employee acquisition and retention in these areas. Given Tesla's success at appealing to those Apple employees with a desire to work on automobiles and energy projects, this issue will become much more interesting when it's time for Apple to see if there is anything they can add to the transportation and energy industries. When that time comes, the quality and excitement of the potential plans and projects will dictate how successful Apple will be with employee retention and acquisition.

Apple's New Music Strategy

Music is an awkward subject for Apple. Music streaming represents one of the rare instances of Apple losing control of one of its product's life cycle (iTunes and the move from paid downloads to streaming). In some ways, this should not be considered too big of a deal since the music business is a fraction of its former self as the product has seemingly been commoditized. In reality, it is more complicated, as Apple's future product aspirations remain aligned with content, just not in a way that most people think. Music streaming and piracy will force Apple to reluctantly pivot its music strategy. While one can harp on the fact that Apple is incredibly late to the game, there are signs that Apple has already settled on a new music strategy: curation and discoverability. 

Music was the lifeline that Apple was desperately searching for in the early 2000s. Positioning a breakthrough user interface as the primary selling point, iPod and iTunes revolutionized what it meant to buy and consume music. Today, music is different. I asked a simple question on Twitter earlier this week: Where do you get your music? The answer wasn't simple: iTunes, iTunes Radio, Beats, Spotify, Bandcamp, Google Play, Amazon, Pandora, CDs, Kickstarter/PledgeMusic, Deezer, Emusic, Spinrilla, YouTube, Bleep, Boomkat, Soundcloud, Rdio, eBay, blogs, Sirius XM.

At first glance, such a situation would seem pretty bleak for Apple as music consumption is no longer tied to using iTunes. In reality, there is still a way for Apple to regain a standing with music and it involves taking a page from the iPod/iTunes playbook: software. Differentiation in music still exists through curation and discoverability, although it remains obscure and clunky. Faint elements of social can be found throughout the entire process. Ask someone why they choose Soundcloud over Spotify or iTunes and you will get an answer. While it is debatable whether that answer is easy to replicate, the point is there is an answer. People still consider there to be some level of uniqueness in terms of how they discover music. Apple's goal is to position Beats as the answer to music's software problem. Mark Gurman over at 9to5Mac reported earlier this week that Apple's plans for Beats includes an interface redesign that sits on top of Beats existing technologies and content, while reintroducing some social elements into the service.

Apple can use software to develop a music platform where curation and discoverability guide the experience; something that was always an afterthought in iTunes. Apple's entry into paid streaming may be the start of a long journey leading to artist sustainability beyond music sales, which I discussed a few months ago in my longer-term view of the music industry. While a few companies have determined that the value is in producing and owning content (music, video), Apple's success with selling devices used to consume content changes the equation. Apple is able to create more value as a gatekeeper between an overwhelming amount of content and the end user. The company owning or distributing (cable/internet providers) the product is unable to fully embrace curation due to the inherent conflict with its business model. Add in the requirement of still needing hardware to enjoy content, and a long-term content/hardware strategy is born. 

There are still some questions that need to be answered. If I'm positioning the software behind the content as the value proposition, how does Apple benefit if the end product is available on competing platforms? One way would be to embrace the idea that a service available to 100s of millions of additional users on Android can be used as a way to not only guarantee proper levels of music industry support, but also market a vibrant iOS ecosystem. I have a choice: use Beats music streaming on my Android phone, or enjoy Beats music streaming in my iOS ecosystem (iPhone, Apple Watch, Mac, Apple TV). Having iTunes on Windows helped sell iPods, with a delayed benefit to Mac sales. What if a Beats app on Android helps sell the music service itself (since critical mass is important for discoverability), with iOS devices receiving the delayed benefit?

Apple isn't taking an easy path when it comes to rethinking music as some of their actions have been somewhat forced upon them by outside factors. Nevertheless, Apple remains in an interesting position to utilize their software and hardware solutions in order to remove friction from the equation. Curation and discoverability represent Apple's best shot in music. 

Apple Watch: A Superb Economic Moat Years in the Making

One of the more intriguing subjects that continues to puzzle me is Apple Watch competition. I struggle coming up with companies, or even industries, that are in a position to ship a credible threat to Apple Watch. While several companies have indicated interest in entering the space, I have doubt these players know where that space is even located. Apple has been building one of the company's largest economic moats in years with Apple Watch, a device with competitive advantages created from wrapping hardware, software, apps, and services into experiences. Apple claims the Apple Watch is only the beginning, while competitors aren't even sure what is about to begin.  

Repeat of the iPad?

When Apple introduced the iPad in 2010, it took the competition a number of years to even figure out what made the iPad so "magical"; the experience from using a device where software and hardware combine to make the hardware melt away.  I suspect a similar situation may occur with Apple Watch, only this time the economic moat surrounding the device may be a lot wider and deeper than it ever was with iPad.

Apple Watch Competition Sources

Luxury Watch Industry. Since Apple Watch will be worn on the wrist and Apple has stressed the device's luxury and fashion tendencies, it is natural to look towards the luxury watch industry for some kind of response to Apple Watch. Soon after the device was unveiled, the attitude towards Apple Watch was one of laughter and mockery. In recent weeks, several watch manufacturers have announced plans to ship their own smartwatch, competing against a device they had brushed off only a few months prior. The primary issue with expecting much of a competitive threat from a company like Swatch or TAG Heuer is that the value proposition of a luxury watch is different than that of Apple Watch. Luxury watches rely on craftsmanship and timelessness because their utility proposition was replaced years ago by phones. With the Apple Watch returning utility to the wrist, craftsmanship shifts to include hardware and software, while timeliness melts away. When a company's primary selling point is shipping a watch that can last forever, it will be hard to compete with a luxury device that positions time-keeping as merely a feature and is intended to be replaced every few years. Ultra-luxury watch manufacturers? I doubt they will even attempt to compete with a $349 gadget for the wrist that can be worn while working out. A $10,000 Marc Newson Apple Watch collection may be another story. 

Technology Industry. If utility is returning to the wrist, technology companies would surely be in a position to come up with hardware devices controlled by software. We already see various smartwatch options being shipped today, although none have the right ingredients to truly stand out. Adding the requirement of having to wear the device adds a layer of complexity that I doubt most in Silicon Valley grasp. Fashion and design will matter more than a wearable's technological capabilities. Having a device on one's body extends that user's personality and emotion to something that will be on public display. The negative public reaction thrown at Google Glass serves as a prime example of technology lacking industrial design elements. Even then, designing a good product isn't enough. Fitbit and Jawbone bought in top designers to create their wearables, yet the devices haven't found success beyond niche markets as many question their utility and performance. 

Fashion Industry. With a clear understanding of how fashion develops and morphs over time, those involved in the process of turning fabric and material into expression would be in a position to capitalize on the ability to appeal to a user's comfort level with wearables. However, the addition of technology into the discussion means that outside resources will need to be brought in to compete against Apple Watch.   

Fitness Industry. The fitness industry had been one of the leading purveyors of the wearable industry. Nike exited the space in 2014, most likely in recognition of moving beyond a core competency and spending resources on not only the wrong bets, but at the wrong casino. The primary problem facing fitness companies and wearables is that fitness is niche. Appealing to fitness tracking limits the use case even further. The triathlon industry is well served by wearable gadgets from Timex and Garmin (among others), but with an addressable market numbering less than a few million, the numbers just aren't there for broader applications. Instead of pushing the idea of fitness, Apple will focus on health, a much boarder application that, in theory, applies to everyone. The biggest roadblock with health monitoring is that the concept indirectly advocates for behavioral change, including diets, routines, habits and schedules. 

Entertainment Industry. Since today's culture seems to elevate celebrities and stardom, I wouldn't be surprised if there are a few attempts in Hollywood to monetize millions of Instagram followers into merchandising opportunities dealing with wearable devices that have to do more with what it says about the user than actual utility. Of course, lack of longevity would be a risk, but at that point, I doubt it would be a concern for those shipping such a product. 

Other. There is always a possibility that single use-case devices could gain a solid footing, such as is the case with Disney's MagicBand, or a health-focused wrist band subsidized by insurance companies, threatening multifunctional devices like Apple Watch. Such specialized devices will not focus on the technology, design, or even utility, but rather some kind of limited, but intriguing experience. I would classify this type of idea as the true wildcard.  

Partnerships and Acquisitions

The most likely source of Apple Watch competition will initially come from partnerships between the luxury watch industry and technology companies. TAG Heuer has already hinted at combining forces with a Silicon Valley firm, and it is not too much of a stretch to think of a scenario where technology companies partner with fashion houses in order to understand how to sell a wearable. Partnerships haven't exactly had the best outcomes in the past and I wouldn't expect anything to change in wearables. Partnerships are formed with the stated goal of joining forces, bringing together resources from two (or more) organizations. However, in that process of combining ideas, differing business models and organizational structures add complexity and friction that turn two companies working together to make an amazing product into two companies becoming desperate, cutting corners and making mistakes in order to stay relevant.

M&A within the current smartwatch industry is also possible as a near-term solution to appease shareholders and board of directors. Considering the deep pockets of large cap tech relative to many possible target valuations, these acquisitions would be sold as low risk/high reward, similar to how every other tech acquisition is marketed.   

Apple Watch Competitive Advantages

The Apple Watch embodies Apple's philosophy of combining multiple disciplines (technology, health, arts, payments) into one experience. Competitive advantages include:

1) Engaged iPhone User Base. Apple Watch is dependent on iPhone for a few reasons, including being able to send computing requirements to a much bigger battery. Having an engaged base of more than 400 million users (most using the latest software) is an advantage Apple holds that currently no other company can match. 

2) Technology. By relying on customized components, such as the Apple S1 chip, Apple will force competitors to cut corners with less attractive alternatives where the end goal is to have as few compromises as possible. 

3) Efficient Supply Chain. Apple has built a supply chain that is capable of producing nearly 100 million iOS devices in a quarter. The ability to efficiently scale production of not only Apple Watch 1.0, but updates and new versions in subsequent years, is an asset that can not emphasized. Apple's ability to control various component supply, such as sapphire watch faces, could also pose a problem to competing products. 

4) Vibrant Developer Ecosystem. As seen with iPhone and iPad success, developer support is crucial for ushering in personal technology with Apple Watch. While the current level of developer functionality found in WatchKit may be underwhelming to some, developer interest in the device exists with many wanting to try the device before thinking of ways to expand iOS apps to Apple Watch. 

5) Apple Retail Stores. Apple's 447 retail stores provide a great opportunity for consumers to try Apple Watch in a setting managed by Apple. While 447 points of sale will pale in comparsion to the eventual network of retailers that will sell Apple Watch, the Apple retail stores serve as a starting point to get millions of Apple Watches out in the wild. The best form of marketing will be word-of-mouth and simply noticing the device being used by early adopters.        

Missing Pieces

One theme when discussing possible Apple Watch competitors is that there are very few entities that hold all of the pieces needed to ship a viable product. For companies focused on luxury design, the technology aspect of the device makes it difficult to do much besides partnering with others. Technology companies likely lack the design talent to turn components into something consumers will want to be seen wearing. Apple Watch's dependency on a phone can also not be understated as any competing device won't have the same vibrant ecosystem to build on, which I suspect is an issue many in the watch industry don't quite fully comprehend. 

Years in the Making 

Apple has spent the past four years creating a device that deserves to take up the few square inches of wrist real estate where proper line of sight and touch accessibility can help usher in a new era of personal technology. I suspect it will take a few years for other companies to even think of the Apple Watch in this way, let alone be in a position to ship a competing product. Companies will monitor how the Apple Watch sells out of the gate to see if the device is worth responding to, only delaying attempts at competing. The Apple Watch relies not only on the latest and greatest smartphones, but design and fashion concepts that are expensive to copy and master. Being able to put all of these pieces together into a marketable product makes it clear that Apple has built quite an economic moat with Apple Watch, and the iOS ecosystem stands to be the primary beneficiary. 

I publish a daily email about Apple called AAPL Orchard. Click here for more information and to subscribe. 

Logic Behind Apple Raising Debt Despite Holding $178 Billion of Cash

Apple raised another $6.5 billion of debt this week, bringing total debt raised to $39 billion. Why is Apple issuing debt despite holding $178 billion of cash? With approximately 89% ($158 billion) of Apple's cash held by foreign subsidiaries, management is relying on free cash flow and debt to fund share repurchases and quarterly cash dividends. Given the low interest rate environment, management is improving Apple's overall cost of capital by borrowing money for less than 1.5% (after-tax cost) in order to repurchase AAPL shares trading at a 13x forward P/E multiple, 5% earnings yield and 6% free cash flow yield. 

Current Capital Return Program

Last April, management increased the share buyback program to $90 billion from $60 billion. Along with the quarterly cash dividend, the total capital return program totaled $130 billion. Apple currently has $17 billion of share buyback authorization remaining and will undoubtedly increase the program in April, as well as raise the quarterly dividend. 

Available Cash for Capital Return Program

Apple had $20 billion of cash available for capital management activities and U.S. investment needs at the end of 1Q15. After Monday's debt issuance, Apple now has more than $27 billion of cash in the U.S. If management were to use the $158 billion of cash located offshore for share buyback or dividends, Apple would be liable to pay 35% U.S. income tax on the repatriated funds. Considering that Apple is able to issue debt at a 2-3% yield with a tax break related to interest expense, it is easy to see that paying 35% tax on offshore cash is not in Apple's best interests. While there are financial techniques that allow Apple to "use" funds located in offshore subsidiaries for U.S. business purposes, the intricacies of such arrangements are for another post. 

Due to Apple's global operations, approximately 40% of total free cash flow is available for capital management and routine cash needs in the U.S. If Apple were to pin its share buyback to just U.S. free cash flow, Apple's overall cash total would grow to hundreds of billions of dollars and investors may start to discount the cash (one of the primary reasons for the buyback). Instead, Apple has set a buyback pace that exceeds annual U.S. free cash flow, requiring management to raise debt (both short-term and long-term, as well as commercial paper, which is very short-term debt) to supplement free cash flow.

Apple's 1Q15 Cash Flow

A look at Apple's 1Q15 10-Q helps frame the math behind Apple issuing debt to fund share repurchases. For the three months ending December 27, 2014, Apple reported operating cash flow of $34 billion, which reflects net income and then all of the other non-cash line items that flowed through the income statement, but had no impact on cash.  In terms of capital expenditures, Apple spent $3 billion on property, plant and equipment. This can be a range of items and for this exercise it really isn't that important. Subtracting the $3.2 billion from $33.7 billion, would give free cash flow (FCF) of $31 billion. A few weeks ago, I recorded a brief tutorial on free cash flow, which is a better representation of a company's underlying financial health than earnings. Keep in mind, this $30.5 billion of FCF is for the entire company.  A few other calculations would suggest that approximately 40% of FCF, or $12 billion, is available in the U.S. 

Moving down the cash flow statement to cash flow from financing, Apple spent $3 billion on dividends and $5 billion on share buyback in 1Q15. Proceeds from debt (the Euro denominated debt) totaled a little more than $3 billion, while Apple repaid $2 billion of commercial paper, leaving $1 billion of net debt issued. Subtracting the issued debt from dividends and share buyback cash flows leads to cash flow from financing of $7 billion, which means Apple used $7 billion of cash to cover share buybacks and dividends last quarter. Since U.S. FCF was $12 billion, Apple had enough to not only cover its capital return program, but also add to cash levels. 

While Apple had enough FCF to satsify its capital management initiatives last quarter, Apple's holiday quarter is historically the largest quarter from a revenue and profit viewpoint with declining cash flow levels for the rest of the fiscal year. In addition, Apple's capital management pace is much more robust than $5 to 7 billion a quarter. Apple's accelerated share repurchase program meant that Apple prepaid $9 billion in 4Q14 for shares repurchased in 1Q15. Going forward, Apple is more likely to be on a $10-$12 billion quarterly pace for share buyback and dividends, which would require additional debt issuance. 

Math Behind Issuing Debt to Fund Share Buyback

Running with a hypothetical example using the $6.5 billion of debt issued this week, as seen in Exhibit 1, Apple could take the additional capital, buy back 54 million shares, save on dividend expense, and essentially end up paying a net of $46 million per annum to borrow $6.5 billion. 

Exhibit 1: Hypothetical Apple Scenario for Issuing Debt to Fund Share Buyback 

Apple's $39 billion of long-term debt has a 2.0% average effective interest rate. Taking into account that interest payments are tax deductible, Apple is effectively paying 1.3% per annum to borrow cash. With shares trading at a 13x forward P/E multiple, 5% earnings yield and 6% FCF yield, taking excess capital to buy back stock is a cost effective way of improving Apple's cost of capital. I wouldn't expect any significant change to this strategy in the near-term as long as interest rates stay low and Apple's business prospects look promising.