Apple: What it’s like to drown in cash

May 6, 2013, 12:44 PM UTC
Photo: Dan Saelinger

As the power and breadth of the Fortune 500 goes on display in this issue, one of its best-known companies, Apple, stands out for so many reasons they are barely countable. In the list itself, Apple is the star, unchallenged. Once a tag-along, it has mountain-climbed to No. 6, with $156.5 billion in revenues. Its 2012 profits were an eye-popping $42 billion (second only to Exxon’s $45 billion); its market value of $416 billion led all others at our March measurement date, and it has a pure monopoly on 10-year shareholder returns: first in earnings-per-share growth, with an incandescent annual rate of 86%, and first in total return, with an annual 54%.

Yet in the real world of early 2013, Apple looks both battered and confused. It is starring, so to speak, in two Wall Street movies that feature Bond-like suspense, with no certainty of happy endings. One movie turns on the convulsions in Apple’s stock: the zoom in 2012 to $700 per share; the plunge within months to a range around $450; a wild dip in mid-April to — wow! — $385. Good theater, for sure (unless you happen to be a shareholder who bought a high-priced ticket to the show).

The second movie, whose plot we will explore in this article, has nearly equal drama: Its subject is Apple’s cash, which for all the years that founder and CEO Steve Jobs lived simply piled up, earning small fixed-income returns and staying immune to the notion that it might better have been employed in the hands of shareholders. After Jobs’ death from cancer in October 2011, Apple’s board embraced the shareholder notion a little, initiating a dividend and announcing a modest buyback of shares. But so profitable was Apple that the cash never stopped growing. It is now a colossal $145 billion, simply more cash than any nonbank corporation has ever accumulated.

And, oh, one more thing, as the late Steve Jobs was wont to say as he concluded a product presentation: Nearly 71% of Apple’s cash — that would be the memorable sum of $102 billion — is trapped overseas. To return it to the U.S., where it could be freely distributed to shareholders, Apple would be hit with very large U.S. taxes. This threat hangs over many other multinationals, particularly tech companies rich in intellectual property, and it drives them wild. Apple’s situation stands out simply because the company is so stuffed with cash.

No case, furthermore, can be made that Apple needs more than a small fraction of that money to operate its existing business; maybe $20 billion would provide it a luxe life. So the situation is something of a mess. Stacks of money rarely deserve the word “problem,” but Apple’s heap merits that rap.

After years of denial, the company has just implicitly conceded that’s true, though it does not speak the word “problem.” On April 23, acknowledging that the fall in Apple’s stock had been “frustrating,” CEO Tim Cook said the company would greatly increase its distributions to shareholders. It is raising its dividend by 15% (going to an annual payout of about $11 billion) and adding $50 billion to the $10 billion that was already authorized for buybacks of its stock by the end of 2015. Spending $60 billion over three years on buybacks would certainly be big. Right now, Microsoft probably holds the record in this department, having spent $59.3 billion over the three years 2006-08. The similarity of the two figures does raise a question. Do we not suspect that Apple is deliberately outdoing Microsoft? More to the point, will Apple’s maneuvers revive its stock price? (So far, the results have been tepid for Microsoft.)

Another revelation of Apple’s announcement was that it would borrow in the U.S. debt market to finance a part of these stockholder distributions. Doing so would crush a bedrock Steve Jobs rule: no debt. But the borrowing will simply be necessary to carry out the plan, because Apple is expected to lack enough cash in the U.S. to fully fund the dividends and buybacks — and, remember, the cash offshore cannot be used for those purposes. Still, the mere statement of the facts is mind-boggling: Apple, which has not a penny of debt and which is a corporate Fort Knox with $145 billion in cash, is primed to start borrowing billions in the U.S. so that it can sweep billions out the door in dividends and buybacks. (On April 30th, after this article was published, Apple sold $17 billion in debt.)

Steve Jobs disliked buybacks, to boot (of that, more later). Were proof ever needed that the ghost of Steve is not today running Apple, it was laid forth on that April day. But the weird position Apple is in, both in good things and bad, was of course also Jobs’ doing. A vignette from an earnings call will suggest the way cash figured in Apple’s culture. An analyst named Harry Blount came on the line with a polite but pointed question about the company’s cash. “From a shareholder perspective,” he said, “it isn’t a good use of capital, as you well know, to have that level of cash with low returns … Any plans to do anything with the cash at this point?” The answer, from Apple chief financial officer Peter Oppenheimer, was, essentially, “No.” He stressed the need to maintain flexibility to invest in the business — adding, though, “We do discuss share buybacks and other forms of returning cash to the shareholders with the board from time to time.”

That was six years ago, in April 2007. Apple’s cash then was about $13 billion — and it has since multiplied more than 11 times, to that $145 billion. The cash just grew like some beanstalk on steroids, tended — or should we say fertilized? — by that maniacal but genius gardener named Jobs. Two products especially fed the beanstalk: the exceptionally profitable iPhone, introduced in 2007, and the iPad, launched in 2010.

For several years of earnings calls, meanwhile, one analyst after another hauled out the cash figure, floated the distributions-to-shareholders question, and kept hearing versions of “No.” Oppenheimer was joined in his turndowns by Cook, Apple’s chief operating officer until 2011, when he became CEO. Even Jobs himself, participating in his last analysts’ call in 2010, presented his own variation of Apple’s answer to the analysts. Jobs referred mysteriously to “one or more very strategic opportunities” — not including, he said, “stupid acquisitions” — that might come along and require Apple to have ample cash. Eh, what? Maybe Jobs was dreaming about acquiring part of the cellular spectrum or making Apple a phone company that could ace out the carriers who served as middlemen in taking the iPhone to market. Or maybe Jobs had just embroidered the truth, as he habitually did, moving into what Apple colleagues dubbed his “reality distortion field.”

No good evidence, in any case, exists that Jobs ever thought about the welfare of Apple’s shareholders. His passion and obsession was products — perfect products. If shareholders got rich from those, that was fine with him. But it was the products that satisfied his soul.

And the Apple board, largely handpicked by Jobs but charged by law with representing the shareholders? Walter Isaacson’s bestselling 2011 biography, Steve Jobs, says that the boss brooked little pushback from his board — overriding, for example, the opposition (unwarranted, as it turned out) of some directors to building Apple stores. Jobs’ grip on the board is also implicitly confirmed by the fact that only after his death did it step up to Apple’s dividend and, concurrently, the planned three-year buyback of $10 billion of stock. But for all the hype these steps got when they were announced in early 2012, they added up to a puny plan, expected by Apple itself to cost no more than $45 billion over three years. In the meantime, the company was on track to capture at least double that amount in cash flow — and end up with the same bulging bank vault it started with.

Even so, those distributions can be thought of as a watershed in the great saga of Apple’s cash. The board includes smart executives of major companies — directors like Bill Campbell of Intuit, Millard “Mickey” Drexler of J. Crew, Arthur Levinson of Genentech — and their decision to pay out even small amounts of cash, and particularly to do buybacks, suggests they had escaped what’s sometimes called “the Steve effect.” Tim Cook, meanwhile, progressed in the last year to overt admissions that Apple was awkwardly cash-heavy. Said Cook at a Goldman Sachs technology conference this February, “The serious issue on hand is the return of cash: how to do it, how much to do.”

Of course, Cook had also by that time been forced into talk of cash by a big, antsy shareholder, David Einhorn of Greenlight Capital, in Manhattan. Owning about $700 million of Apple in his funds at the end of 2012, Einhorn decided in early February to go public with a complex plan for getting some of Apple’s cash to its owners. Einhorn recommended that Apple start giving its common shareholders — yes, for free — shares of a perpetual preferred stock (which Einhorn named iPrefs) whose annual dividend would be $2 and whose trading price would be set by the market. A shareholder could therefore choose to sell this new piece of paper he’d been given — maybe, Einhorn thought, for around $50.

That wouldn’t take money out of Apple’s pockets, but the dividends on the preferred would. Initially, each common share of Apple would be entitled to one share of the preferred, and that would only lead to $1.9 billion a year being paid out in dividends. But Einhorn visualized iPrefs gaining popularity as a concept and Apple therefore deciding to give away still more of them to the common shareholders, until the annual dividends mounted to $9.5 billion and were taking a real slice out of Apple’s cash.

Asked about this plan at the Goldman conference, Cook did not give the slightest indication that the concept had gained popularity with him. Cook did say the plan was “creative” and would be thoroughly evaluated by Apple as it dealt with its how-much-to-do, how-to-do “serious issue.”

It should be noted, of course, that the uses of cash are not limited to dividends and buybacks. Capital allocation, which is what we’re talking about and which so many companies tend to flunk, certainly begins with the intelligent use of cash internally. Surfeited by cash, Apple did indeed pump up its capital expenditures: They were less than $1 billion in 2007 and up to $10 billion last year. The opening of new Apple stores usually consumes a minority portion of these annual outlays; the rest goes to assorted capital projects. Over the past few years, Apple also ramped up spending on its supply chain, making component prepayments and buying equipment for use by its suppliers — no doubt for a payback that made sense.

But that financial gesture is telling in what it says about both Apple’s structure and its sparse need for cash. Inside Apple, a 2012 book by Fortune senior editor-at-large Adam Lashinsky, insightfully identifies Apple as vertically integrated in the sense of its controlling every aspect of getting a product to the market. But that does not make Apple capital-intensive — nor vertically integrated in the standard sense — because practically always its suppliers own the manufacturing plants in which Apple is autocratically exerting its control. That is exactly the way Apple likes things. It does not want to own plants in China or South Korea; it would rather play the role of tough customer, buying components from such suppliers as FoxConn and Samsung (while that Korean company makes a smartphone that is cutting deeply into iPhone sales).

Neither does Apple appear to have any appetite for spending its cash to buy some large company — even though its cash is so towering that it exceeds the market cap of 482 companies in the 500. But recall Steve Jobs’ dismissal of “stupid acquisitions.” In its Silicon Valley headquarters, Apple is surrounded by examples of bad acquirers — Hewlett-Packard being one horror case. Apple’s own interests for many years have run to small, tuck-in acquisitions that fill a particular need. The company’s purchase of voice-recognition enterprise Siri in 2010 (for a price that was not announced) qualifies as the type of deal Apple likes to make.

At least some shareholders, though, believe Apple should be trolling for more ambitious acquisitions that could soak up major parts of the company’s cash and convert it to earning decent returns. One institutional shareholder told Fortune recently that his company believed that Internet enterprises whose DNA would fit Apple’s were the direction to go. The company had in fact suggested several such buys to Apple. They included Twitter, auto navigation service Waze, and messaging system WhatsApp. You couldn’t Tweet favorably on what those companies make right now, but their potential is what the shareholder had in mind.

Another kind of acquisition — often the best — is your own stock, which puts a manager to buying the company he knows better than any other. But that proposition certainly didn’t impress Steve Jobs. He not only ruled out buybacks entirely at Apple but also argued against them at another company, Disney, where he was the largest shareholder and a board member. Disney CEO Robert Iger (who bought in stock despite Jobs’ views) recalls that “Steve was generally not in favor of Disney buying back its stock.” Jobs had seen real trouble at Apple — very tight days for cash in the late 1990s — and he thought money should be hoarded for a “rainy day” or for capitalizing on some big opportunity. A perfectionist about almost everything, Jobs also hated the fact that buybacks cannot by their nature be perfect: Time and again a company will buy back stock and then see the price fall to less than what it paid. Iger says Jobs regarded that as a destruction of value. (Iger, who became a director of Apple soon after Jobs died, felt free to tell Fortune about Jobs’ time at Disney but would not discuss Apple with us at all.)

Eventually, as the cash mounted at Apple, Jobs decided to consult a man famous for knowing what to do with money, Warren Buffett. The two men had known each other when both were on the board of Grinnell College in the 1980s. Phoning Buffett, Jobs asked for thoughts about Apple’s spare cash. Buffett discussed buybacks and stated his prime criterion for them: “Do you consider your stock cheap?” Jobs said he did, absolutely. “Then the best thing you can do with your cash,” said Buffett, “is buy in shares.”

Buffett believes this conversation took place in early 2010, when Apple stock was trading between $200 and $250. The date, in any case, became irrelevant because Jobs paid no attention to Buffett’s advice. The lore is that Jobs instead descended into his reality distortion field, letting at least some people at Apple believe that Buffett had recommended doing nothing.

After Jobs died, though, with Apple stock pulsing around $400, Tim Cook made his own call to Buffett. Cook said he had favored a buyback program when Jobs first called Omaha — and what, said Cook, should we think about buybacks now? Again Buffett said, “If you think your stock is cheap, buy it.”

Whatever impact this advice had on Cook, Apple did not announce it would roll out a buyback program until March 19, 2012, when the stock was $600, and did not begin purchasing shares until September, when it was marching toward its high of $702. Steve Jobs must have rolled over in his grave: purchases at highs, followed by the plunging prices that began right after that top was hit.

Nonetheless, modern finance appears to have reduced Apple’s pain. Apple chose to do its buying — $1.95 billion worth — through what is called an “accelerated share repurchase” (ASR), which outsources the buying to a financial institution and typically has the effect of delivering the repurchasing company no higher than a weighted average price for the stock, over an extended period of perhaps six months. So Apple’s per-share purchase price got averaged down. We know that because it reported in an SEC filing coincident with its April 23 announcement that this first Apple buyback had concluded with about 4 million shares bought at an average price of $478.

The board that will have Apple’s buybacks under its eye includes former U.S. Vice President Al Gore. But perhaps this board’s most distinctive feature is that it includes a striking number of bosses, current and former, who have bought in stock for their own companies: Iger, as mentioned; Drexler, at J. Crew, when it was still a public company; Bill Campbell, at Intuit; Andrea Jung, former CEO at Avon; Ron Sugar, retired CEO of Northrop Grumman. It is easy to imagine these directors (save Iger, who wasn’t there yet) highly frustrated at Jobs’ unwillingness to do buybacks. But that is only guessing, since no director has told us that it is true.

As this article is published, Apple is six days past its April 23 announcement and dealing with a stock that has reflected very little excitement about increased dividends and the buybacks to come. Most of the commentary about the company has focused instead on the quarterly earnings decline it announced simultaneously — its first in 10 years — and a shortage of new products, the kind available right now, to spark the famous Apple magic.

As they watch the stock’s action, Apple’s managers and directors can also recollect just what dividends and big buybacks didn’t do for Microsoft, which instituted its first cash dividend in fiscal 2003 while also continuing a program of buying in its stock. From the end of 2002 through 2012, Microsoft spent no less than $185 billion on dividends and buybacks. With the company’s share count declining by 22%, earnings per share rose 189%. And Microsoft’s stock? It went up, year-end to year-end, by only 12%. The stark reason has been the company’s failure to come up with hot new products to join the old bunch — such as Windows and Office. That makes its prospects uncertain, and its stock just doesn’t rise.

Apple has 10 years of spectacular success behind it, one down quarter, and a business future that is right now likewise wrapped in uncertainty. So its stock whips around, while the company brings on a new weapon: cash. In the end, though, the arsenal that will propel the stock, if that is to happen, is a stream of new products and services that will fuel earnings — and very likely create another buildup of cash.

Reporter associate: Doris Burke

This story is from the May 20, 2013 issue of Fortune.