Apple should shrink its finance arm before it goes bananas

By davicole

IT IS fashionable to say that tech firms will conquer the financial services industry. Yet in the case of Apple, it seems that the opposite is happening and finance is taking over tech by stealth. Since the death of Steve Jobs, its co-founder, in 2011, the world’s biggest firm by market value has sold hundreds of millions of phones with bionic chips and know-it-all digital assistants. But it has also grown a financial operation that is already, on some measures, roughly half the size of Goldman Sachs.

Apple does not organise its financial activities into one subsidiary, but Schumpeter has lumped them together. The result—call it “Apple Capital”—has $262bn of assets, $108bn of debt, and has traded $1.6trn of securities since 2011. It appears to be run fairly cautiously and is part of a thriving firm, but it still deserves scrutiny. Companies have a history of being hurt by their financial arms; think General Electric (GE) or General Motors (GM).

Apple Capital has lots of responsibilities but three stand out. It invests the firm’s mountain of surplus profits, mainly in “highly rated” instruments (this task seems to fall to Braeburn Capital, a subsidiary in Nevada, which uses some external fund managers). Apple Capital also uses derivatives in order to protect the firm against currency and interest-rate gyrations. And it manages America’s fifth-biggest corporate-debt pile by issuing Apple bonds as part of an elaborate strategy to limit tax bills.

Apple Capital has become important to its parent. Since Jobs died, its assets have risen by 221%, twice as fast as the company’s sales, reflecting Apple’s huge build-up of profits. Its investments are worth 32% of Apple’s market value, and its profits (investment income, plus gains on derivatives, less interest costs) have been 7% of Apple’s pre-tax profits so far this year. It is also sizeable compared with other financial firms. Consider four measures: assets, debt, credit exposure and profits. Depending on the yardstick, Apple Capital is 30-85% as big as Goldman Sachs. It is 22-42% as large as GE Capital was at its peak in 2007, just before things went down the tubes during the subprime crisis.

Apple Capital is different from these firms in important ways. It does not take deposits and has much lower leverage. In their prime Goldman and GE Capital were run by hard-charging financiers, and made lots of loans. By contrast, Apple Capital does not make loans, and is not meant to be a profit centre in its own right. Nonetheless, it has become riskier, in three ways.

First, Apple Capital is investing in racier assets, which involves taking credit risk. In 2011 a majority of its assets were “risk-free”: cash or government bonds. Today 68% are invested in other kinds of securities, mainly corporate bonds, which Apple says are generally investment grade. The shift may explain why Apple’s annual interest rate earned on its portfolio (2%) is now higher than that of the four other Silicon Valley firms with money mountains, Microsoft, Alphabet, Cisco and Oracle. In total, they still have 66% of their portfolios squirrelled away in risk-free assets.

Second, Apple’s derivatives book has got much bigger. Since 2011 its notional size—the face value of its contracts—has risen by 425%, to $124bn. This is still much smaller than big banks’ positions, but is the third-largest book of any non-financial firm in America, after GE and Ford. For every dollar of foreign sales, Apple has 89 cents of derivatives, compared with 57 cents for the other four tech giants. At points these derivatives have yielded big rewards. In 2015 they contributed $4bn, or 6% of Apple’s profits. But they have dangers, too. Apple says that its “value-at-risk” (VAR), a statistical measure of the maximum likely loss in an average day, is $434m. That is huge: similar to the combined VAR of the world’s top ten investment banks. In theory losses on derivatives would be offset by gains in the value of Apple’s underlying business. But the sheer size of these positions gives pause for thought.

The last area of higher risk is Apple’s divided geography. Its foreign operation swims in cash while its domestic one drowns in debt. Profits made abroad are kept in foreign subsidiaries. That way Apple does not pay the 35% levy America charges when earnings are repatriated. Some 94% of Apple Capital’s assets are “offshore” and cannot be tapped for ordinary purposes. The domestic business must do the hard work of paying for dividends and buy-backs. Its profits are not big enough to cover these, so it borrows. Domestic net debts have risen to $92bn, or five times domestic gross operating profits. Each year Apple must issue $30bn of bonds (including refinancing), similar to the average of Wall Street’s five largest firms.

Apple’s core business is so profitable that it is—almost—inconceivable that a blow-up at Apple Capital could lead to it needing taxpayer or central-bank support, as was the case for GM and GE. Still, it is easy to imagine how Apple Capital could hurt its parent. A market shock could lead to losses on its portfolios. A two-percentage-point rise in interest rates would result in a loss of $10bn. If bond markets dried up, Apple might struggle to issue so much debt and have to bring home funds, incurring a big tax bill. It might also become tricky to run such a big derivatives portfolio.

Don’t upset the Apple cart

Apple Capital has grown in a forgiving period for financial markets. That won’t last. Over time, the risk of mission creep will rise, as will the temptation to invest in riskier assets. On the current trajectory, by 2022 its assets will reach $400bn and debts $250bn. By then financial regulators, who do not supervise Apple, will be grinding their teeth at night.

According to a former manager who left in 2012, Apple’s financial gurus were careful because “nobody wanted that 3am call from Steve Jobs”. But Jobs isn’t there any more. In any case, a fear of rebuke is not enough. If the tax laws change Tim Cook, Apple’s boss should wind down the structure that the firm has created. But even if the rules don’t Apple Capital should be shrunk. Tech firms should seek to disrupt finance, not be seduced by it.