what's wrong with apple

Too much cash is bad
Too much is too bad is what we have known for long. But we thought cash was an exception for there isn't diminishing marginal utility here.

It looks like too much of cash can also be a problem. As of now cash with Apple is at about $140 billion, that's a staggering number. The problem of plenty is quite unique indeed.

That is exactly what has become one of the problems Apple is facing today. From becoming the most valuable company in the world to becoming not the most valuable company, the journey of its value has been quite interesting. Take a look:

The market value down from about $650 billion to about $440 billion. That is $210 billion marked down in just 6 months. What is going on here? The world is divided. There are those who swear by that name, Apple and have all sweet stories to talk about; and there are those who say that all that rises has to fall someday, laws of nature. And there are those who are clearly not happy with $210 billion loss. These are the shareholders who think that Apple is worth much more and market is stupid to act the way it has. Their solution for fixing the problem is efficient use of cash. They think that market is discounting the value of cash held by Apple and once this is resolved the value will restore.

The business
Before we dwell on to this we should have a look at Apple's business. It is currently operating without any meaningful capital and generating about $156 billion of revenue, about $55 billion of pre-tax operating income and about $42 billion of free cash flows. It's one crazy business model, defying all reasoning. Hardly any input, but output is plentiful. It has been a cash-generating machine so far.

Will this continue? Operating margins are falling. Competition is increasing. The fight between Android and iOS is inevitable. Samsung is gaining momentum. There are a number of other players who want a share of the pie. The road is only getting bumpier.

The challenges
For Apple there four important challenges to consider: 1) To maintain the operating margin; 2) To maintain or increase the market share of its existing products, iphone and ipad in particular; 3) To grow its business with innovation; 4) To find effective and efficient ways to use excess cash.

I don't want to predict how Apple is going to handle its first three challenges. It is the last one I want to talk about.

Back to cash
Let us come back to those who feel Apple is currently undervalued and will increase in value once cash is properly dealt with. As small investors, one cannot do much, except bark in agony or excitement. But they can always piggyback on someone who is more powerful and willing to fight. David Einhorn is giving his shoulder to all those weak investors.

The preferred stock proposal, or the game
Einhorn wants Apple to issue a new class of preferred stock that will pay a 4% dividend in perpetuity, which he says will create value unlocking for Apple. He argues that for every $50 billion of preferred the value will increase by about $32 per share. He prefers $500 billion of preferred so that $320 per share value is unlocked.

This sounds interesting, but not realistic, especially if you are willing to recognize the difference between value and price. You can change value by increasing cash flows, or by increasing growth in cash flows, or by making cash flows safer, i.e. more certain than before. I don't see this happening when preferred is issued by Apple. A $4 dividend preferred should appropriately trade at par, not more, not less.

As for the price, we don't know what is the right price for the stock. The current price of $466 may be low, if we consider that the current revenue growth, margins and cash flows will continue; may be high if we consider that revenue, margin and cash flows will be affected going forward. In short, we don't know what is the correct price for Apple.

The stock price of Apple has about $140 of cash which is valued as it is at carrying value and about $326 of operating assets. The debate is related to this $326 per share: whether this is too low or too high for Apple. Let's not confuse this with cash.

If Einhorn feels that Apple is significantly undervalued currently, issue of preferred stock does not sound any logical solution. If his valuation of Apple is correct, eventually market will catch up with his value. To see how, just see the financial performance of Apple going forward. If Apple continues to perform better, its value will go up. There is immense case for Einhorn here to increase his stake in Apple when its price is falling. Why does he want it to go up when he knows that it is undervalued?

If he is not sure of his assessment of true value of Apple and simply wants to make use of his position as a significant shareholder, he is not trying to unlock value, but price. We hope that he knows it.

On the contrary, if Einhorn is successful in unlocking price of Apple stock, and the operating performance continues to slide in future, price will come down to catch up with Apple intrinsic value. If this were so, he would have only created a quick-exit-way for the shareholders by unlocking price. Those who don't exit, will suffer.

The moral of the story
Temporarily you can cheat markets by playing some games. However, over time markets will recognize the true worth and catch up.

Again to cash
Interestingly, Einhorn does not want Apple to part with its cash. Both the management and the board have forgotten the fact that when cash can be better used by shareholders, it should be handed out back to them. Paradoxically, Einhorn is backing management on this when they have failed to use the cash in an effective way.

A substantial amount of that cash is kept in different parts of the world, roughly about $85 billion, which will attract some additional tax if it is to be repatriated to the US.

It is no-brainer that so far Apple has not found effective and efficient ways of using excess cash. Since Apple is holding cash which belongs to its shareholders, the management and the board have a duty to deal with cash in a manner that pleases all shareholders.

The choices available are: reinvestments in the business, cash dividends, stock buy-backs and acquisitions. In the absence of reinvestments, and lest the cash is lost on bad acquisitions, the shareholders would want the cash be returned to them, rather quickly.

As I see it the most efficient way of returning cash and yet please all shareholders is through buy-backs. This is with a caveat that in general, stock buy-backs are not good if the current stock price is substantially higher than true worth of the business.

A fair game
Let us say, $100 billion (or about $100 per share) of buy-backs is done. It should please all groups of shareholders:

The Apple-all-the-way-shareholders will get to reject the buy-back and gain increased ownership and per-share earnings.

The no-Apple-shareholders will be able to accept the buy-back, receive cash which is more than market price (otherwise buy-backs won't work), and exit Apple.

But this proposal is not for the shareholders who want to exit but not at the buy-back price because they feel that the price is substantially low compared to its true worth. Well, that thinking is conflicting. They will have to wait for the market to catch up, or better yet, the preferred game could, but not certainly, help them.

Interesting times
Apple is undoubtedly one of the most widely followed stocks in the world. Everyone wants to know where it is headed and what it will do with its cash.

If I knew the right answers I would have created either substantial long or short positions and made money. Unfortunately, that is not to be.

But I do wish Einhorn well.

governance and social responsibility...the google way

If this report has to be believed, Google, as a corporate, has some serious issues to tackle. It is one thing to be creating value to shareholders (if that has been the case) and another to do that with bad governance and disrespect to social responsibility.

In fact, in corporate finance the debate has been there for ages - whether the corporates are justified in making money at the cost of social justice and equity.

Reading personal emails is bad corporate governance and completely unacceptable. It is a pity that the users do not even know that this is being done. All they care is life as usual, i.e. send and receive emails with no monetary cost. They don't seem to care to find out other things affecting them, busy life, you see.

The report has been initiated by Microsoft, which is a direct competitor to Google. Obviously, there is plenty of bias and envy. So, we need to check out the facts before we respond. However, if Google has been doing what it should not be doing, it is a shame. Corporate ethics seem to have lost somewhere for most of the corporates. They think it is alright as long as they are making money and stock prices are going up.

Google's defence? No human reads personal email; it is all automated.

What do we do?

Dump Google's email service? Dump Google's search engine? Dump the stock?

I don't know.

But what I know is that it is......Shame on Google.

the spirit of united spirits

The spirit business in India is going to be international soon.

Diageo is going to acquire a majority stake in United Spirits. The price: Rs.11,000 crores for 53.4% ownership. That gives a valuation for the entire company at about Rs.20,600 crores. As part of the deal Diageo has initiated an open offer to acquire 26% stake in the company at a price of Rs.1,440 per share.

The consolidated numbers as per 2012 annual report are noted below:

We don't have access to the latest balance sheet. Regulators should do something about it.

Stand-alone basis (quarterly) income statements:

Price movement for the last 6 months shows the real spirit:

At the current share price of Rs.1,895 per share, the market value of the company is about Rs.24,785 crores.

Given large debt and low income, is the price paid by Diageo justified? Acquisitions are usually rationalized by quoting synergy and control as value enhancements. Sure there is synergy in this deal. Indian market for Diageo and International market for United Spirits. And sure Diageo will be able to bring in its own international expertise due to its control. But how much of this will fructify only time will tell.

The present reality is that debt is too high, profits are not that great and there is Rs.5,000 crores goodwill sitting in the books.

Question: Who is going to subscribe to the open offer at Rs.1,440?

Those who want to lose money.

Question: Is Rs.24,785 crores for this business too high or too low?

Remember what I said before....Synergy and control.

Who is kidding here? Time will tell.

deccan chronicle: in search of cash

Deccan Chronicle's results for the 18-month period ended 30-Sept-2012 are out.

The company has changed its financial year from 31-March to 30-September. The annual report is still not out. So we have many missing links as of now.

The company has suffered loss for the period. Sales are down. Costs are high. We don't have information regarding other expenses of Rs.345 crores. Operating losses are about Rs.389 crores. Finance costs are Rs.734 crores.

The whole company is available today at about Rs.100 crores. Of course, if you buyout, you will also get to pay (a financial liability) about Rs.3,903 crores. That's how it is: obligation.

In search of cash
Depreciation for the period is Rs.81 crores. Capex for the period is Rs.3,025 crores (most of which is spent for brand building as per the information provided). We don't know yet to whom these amounts are paid and what brand is being built for the business.

There has been significant savings of about Rs.420 crores from working capital and some long-term assets/liabilities. To put in another way, basically, the operations are down.

Joining these dots we get about Rs.109 crores of cash from operations. See, the cash is out there.

Restructuring of operations and recasting of financial statements
Apparently, there has been restructuring of operations (we don't know what this means yet; as of now as we understand, the operations are down) and recasting of financial statements (we don't know what this means either; recast lets one have new or some different arrangement; recast of financial statements is an interesting idea, though).

Net loans received after all this is about Rs.3,189 crores. This cash is in. But, needs to be repaid with interest sometime in the future. However, it is known currently that this future is not knowable.

There has been buyback of own equity during May-August-2011 amounting to about Rs.228 crores.

If we join the dots again, we get net financing (loans net of interest and buyback) cash inflow of about Rs.2,228 crores.

The reconciliation of cash
So we have operating cash of Rs.109 crores; financing cash of Rs.2,228 crores; and capex of Rs.3,025 crores. That brings net cash loss for the period to about Rs.688 crores. This deficit is financed by, aha! opening cash of Rs.704 crores. What remains as of Sept-2012 is a cash of Rs.16 crores for the company to continue its operations. What a challenge!

More losses to come
The cash loss of Rs.688 crores does not include accrued interest on loans. This means that interest charges have not been fully provided by the company for the period.

Non-performing asset
In the mean time, some (why not all is a question) of the lenders have classified the financing provided to the company as non-performing asset.

Due to the invoking of pledged shares, the promoter shareholding has gone down from 73.83% to 38.4% as of Sept-2012.

IPL franchise granted by BCCI has been revoked. The company claims that it is a contingent asset.

The dive
The performance of the stock has been miserable:

In the past 5 years, the stock is down by about 97%, while Sensex gained about 15%.

This brings down the promoters, the minority shareholders and the lenders. Now we need to find someone to blame: the choices are a) promoters; b) lenders; c) rating agencies; d) analysts; e) all shareholders; f) all of them. Take your pick.

Cash as of now
We need to know what happened to that Rs.16 crores cash that was there as of Sept-2012. If the company has continued to operate, surely, that cash has gone. Ouch!

ril: cost of diversion

Reliance Industries is the company of the country. It has a solid track record of projects execution and returns to its shareholders. It generates loads of cash each quarter.

Let's have a look at what it does with its cash.

Current core operations
The company currently operates in 3 prominent segments: Petrochemicals, Refining and Oil & gas.

The petrochemicals segment includes production and marketing operations of petrochemical products namely, High and Low density Polyethylene, Polypropylene, Polyvinyl Chloride, Poly Butadiene Rubber, Polyester Yarn, Polyester Fibre, Purified Terephthalic Acid, Paraxylene, Ethylene Glycol, Olefins, Aromatics, Linear Alkyl Benzene, Butadiene, Acrylonitrile, Caustic Soda and Polyethylene Terephthalate.

The refining segment includes production and marketing operations of the petroleum products. 

The oil and gas segment includes exploration, development and production of crude oil and natural gas.

These operations are good as these are related businesses. There is synergy in these combinations. These businesses are profitable as we can see from below (consolidated as of 31 March 2012).

Future operations
Then there is another segment which includes - Textiles, Retail, SEZ development and Telecom / Broadband; and more: hotel and TV broadcasting businesses; and more: financial services(?).

The returns
A rough estimate of return on assets employed shows that energy related businesses have provided decent returns to the shareholders. Whereas, other businesses have not.

Bad business
As of March 2012, an amount of Rs. 31,000 crores was invested in these unrelated businesses (as much as about 11% of total capital employed in the company) but gave the shareholders zilch. They are yet to take off.

Excess cash
A large portion of that unallocated amount of Rs. 94,000 crores is actually cash, an excess cash. This cash can be used for repayment of debt, paying dividends or buying back stock. Alternatively, the cash can be used for reinvestment in and expansion of the current related energy businesses.

The company has chosen to keep the cash available for future investments. A small amount has been used for buying back stock.

Bad investments
While a good portion of this cash is planned to be invested in the energy businesses (See this for instance), the worrying factor is that a large portion is planned for investment in unrelated (bad) businesses as well. For instance, a whopping $9 billion (more than Rs. 45,000 crores) in telecom. There is significant investment in retail too. If these investments generate below-average returns over the next decade (no surprises if they do), the opportunity cost to the shareholders, including the controlling shareholders, would be massive. For instance, at 15% returns, Rs. 1,000 crores would earn about Rs. 3,000 crores in 10 years. Try translating this on the investment of the size that the company has envisaged in bad businesses. The difference when compared to the actual returns earned on these investments is the opportunity cost for the shareholders.

Profit margins in retail are very bad; unless you can turn over inventories at a very high rate, you are sure to earn worse-to-bad returns. Let's not talk about telecom / broadband business which is a technology-driven business.

Taking a leaf out of Exxon Mobil
Why can't the company which has a good operating business already stick to its roots? Taking a leaf out of Exxon Mobil would not be bad. Exxon has 3 segments: Upstream, Downstream and Chemicals, all in energy business. Return on capital employed is 26% (Upstream), 19% (Downstream) and 22% (Chemicals). Average for the company is 24%. On about $171 b capital, the return is about $41 b as of December 2011. Current market value of Exxon: about $410 b.

In contrast, Reliance Industries market value is just over $50 b.

Potential in energy business
There is immense potential for the company to grow within its current operating business, viz. energy. India needs energy; the world needs energy. Would it not be good for a Rs. 5,000-plus crore a quarter cash-generating company to get into profitable operations (based on price-value propositions) rather than getting into growth just for the sake of growth?

Imagine the amount of competition in retail and telecom; it's a little optimistic to think that the company, even with its muscle power, will be able to pierce into the competition and make its mark, meaning earn above-average profits.

There is no point providing capital to a business if it is not able to earn more than its cost of capital. That is corporate finance and maximization of shareholder value.

It would have been better for the company to pay heed to the fact that obvious prospects for physical growth in a business do not necessarily translate into obvious profits for investors.

The current year results reflect the following (stand alone numbers 9-month ended 31-Dec-2012):

These stand alone numbers are not strictly comparable to the consolidated numbers mentioned above. Nevertheless, it appears that return on capital is getting affected.

There is no mention of total capital employed so far in retail and telecom operations.

We hope that these businesses yield above-average profits in the years to come. Hope that is. We sincerely hope that this company goes a long way further in the global arena.

voilà! interest rates

One of the main factors that affect prices of any asset held for investment is the interest rate. The more it changes, the more it affects the prices and thus, the investment performance.

So, we have the scapegoat, blame it on the rates.

For bonds it is quicker: It is quite clear that when interest rates go up, bond values fall and vice versa.

For equities it is gradual but sure: For equities, it is the same since the current alternative options (bonds) appear to be more attractive. The opportunity cost of investing in equities goes up, and consequently, their intrinsic value goes down. Cost of borrowing goes up when interest rate goes up. Equities will appear to be overvalued if their prices don't fall to a level that is reasonable. To adjust to a more rational market values, it will take more time for equities than for bonds.

Inflation also is affected by the level of interest rates. So, watch out for that long-term, risk-free government bond rate.

Here's the historical information of the long-term rates in India and US.

Low interest rates during the period 2002-2005 made immense sense to invest in equities rather than bonds. For the last 2 years we have been in the 8%-regime, which is also the mean rate over the long period. One reason it has been holding on to that level is the level of inflation. It hardly makes sense to invest in a risk-free rate lower than inflation. We can argue that when inflation is tamed down, interest rates are more likely to go down. I cannot make a prediction on that.

US is experiencing one of the lowest interest rate periods in its 100-year history. While the economy did extremely well since low rates of 1940s, it is a challenge for it now to replicate its past performance simply because of its sheer size. Now if it can clock a growth rate that is 1.5-2 times its long-term rate it will be a stupendous performance. If you believe in corporate America to increase its profits and cash flows in the next decade and more, this is the best time to invest there. I cannot predict the future rates here as well.

So much for the interest rates and their magical powers.

aig: a strange suit

The company goes bankrupt, seeks help. The savior comes in and offers help in return for a majority ownership; eventually the company survives. The previous owners, now, are furious and suing the savior, and may be the company as well. Strange as it may feel, such is the gratitude.

AIG's share price fell from $70 to $1.25 in Sept-2008, a loss of 98% value. It reported loss of over $13 billion from Jan-2008 to June-2008.

However, since the US government's bailout there has been a steady recovery of the company's market value:

Jan. 7, 2013	58.57B
Sept. 30, 2012	53.45B
June 30, 2012	57.57B
March 31, 2012	58.48B
Dec. 31, 2011	44.06B
Sept. 30, 2011	41.66B
June 30, 2011	55.61B
March 31, 2011	63.14B
Dec. 31, 2010	8.081B
Sept. 30, 2010	5.284B
June 30, 2010	4.652B
March 31, 2010	4.607B
Dec. 31, 2009	4.036B
Sept. 30, 2009	5.936B
June 30, 2009	3.122B
March 31, 2009	2.691B
Dec. 31, 2008	4.223B
Sept. 30, 2008	8.954B
June 30, 2008	70.47B
March 31, 2008	109.09B

From a low of $2.69 b the value has recouped to $58.57 b.

It would be difficult to imagine what would have happened if there was no help from the government. Only based on an analysis of no-help valuation to post-help valuation it will be possible to award justice.

One way to calculate the value of benefit to the shareholders (other than government) would be: The difference between $2.69 b accruing in full and that portion from $58.5 b accruing to them. That is, how much their shares were worth before bailout and now.

It is easy to assume that under bankruptcy the sale of assets would have been at distressed values. Alternative argument from the claimants should be demonstrable. Otherwise the case is void ab initio.