Wednesday, 24 May 2017

Apple’s Core: Moribund Capitalism

Apple Inc is the world’s largest company by market capitalisation, with a value of nearly $800bn on 19 May 2017. It does not produce most of the world’s smart phones, coming in a poor second behind Korea’s Samsung, and it is not that far ahead of China’s Huawei in terms of market share. Neither is it necessarily the biggest player in other consumer electronics markets. But so far it has managed to corner the premium section of these markets, managing to get enough loyalty from customers who will pay a lot more for a product that is not so different from the (much) cheaper ones that are not quite so ‘cool’.
That is principally why Apple, with fewer than 120,000 staff and itself producing very little of the final product that it sells to consumers, can be worth in capitalist markets so much more than Foxconn. Also known as Hon Hai Precision Industry Co, the latter Taiwan-based company is its main assembler, employing more than one million workers, and is currently valued at a relatively minuscule $60bn in terms of market capitalisation. In 2016, Apple’s operating income was $60bn compared to some $4bn at Foxconn, endorsing the market valuation ratio ($800/$60bn).
These points are another sign of the distortion of social value by imperialism, and another day I may write more about the social and economic mechanisms behind this. For now, though, I want to focus on the financial aspects of Apple’s business, mainly using information from its latest annual report.
Most radical, critical commentaries on Apple focus, reasonably enough, on how it uses cheap labour in Asia to boost its profits. What I want to deal with instead are the details in Apple’s accounts that show how its close integration with the world of finance complements and reinforces its commercial power. For example, its use of bond market issuance and equity buybacks to boost revenues for its investors; its huge investments in financial securities, ones that rival the holdings of major investment funds; its use of financial derivatives for both hedging and speculating in financial markets; and its large cash holdings, which are explained both by the nature of its business operations and by developments in world markets.

Debt issues, equity buybacks

Apple has been one of the corporations that has found it more advantageous for its shareholders to raise cash via issues of bonds and other debt securities rather than to issue new equity. Issuing new equity means that a given amount of profit has to be shared between a larger sum of shares held by investors, potentially reducing the rate of return for existing investors, and also their percentage holding in the company unless they buy more shares. However, with interest rates on corporate debt so low, it has made sense for Apple to issue debt, pay the interest and use the new funds to buy back existing equity. Assuming that the rate of return on its regular business was higher than the yield on the bonds, this also helped to keep the payments to shareholders buoyant.
Apple repurchased common stock in each of the 2014-16 financial years: 489 million shares in 2014, 325 million in 2015 and 280 million in 2016. Share issues also took place in those years, but they were small scale, only some 10-15% of the buyback totals. The net effect was for the total number of outstanding shares to fall from 6.3 billion in September 2013 to 5.3 billion in September 2016, a significant drop of 15% in just three years.
Funds for the share repurchases should be seen as principally coming from the debt issues, including short-term commercial paper, although the numbers for the whole gamut of business operations are interlinked. For example, Apple reports that in its 2016 financial year funds worth $29.7bn were used to repurchase common stock, $12.2bn were used to pay dividends and the net proceeds from issuing longer-term debt were $25.0bn.
The scheme of share buybacks continues and, as of September 2016, ‘only’ $133bn out of a total of $175bn authorised by Apple’s board had been completed – a total that was raised from $140bn in April 2016, and could be raised yet again. In addition, Apple has another element of this plan, something it calls a ‘capital return programme’, which is expected to reach $200-250bn by March 2018. The missing element is the (strongly implied) promise to boost dividend payouts. In 2013, total dividends paid were $10.6bn, rising to $12.2bn in 2016. So, with the falling number of shares, earnings per share have been rising rapidly: from $6.49 in 2014 to $8.35 in 2016, a rise of nearly 30%.
This helps explain the astronomical stock market valuation for Apple, one that has increased by some 60% over the past year. It can use the financial markets to boost the returns to its owners, quite apart from the other commercial and political means available to it as a leading corporate power. But what this really reflects is the nature of moribund capitalism today. Having got in a pickle with a big drop in operating income (down 16% to $60bn in 2016), and with net sales declining by 8% in 2016 – led by a 12% slump in the value of sales for Apple’s main product, iPhones – the company adapts to these setbacks more by financial operations than by innovation or investment.

Investment in securities

While iPhones do not generate for Apple as much revenue as before – just $136.7bn in financial year 2016 compared to $155bn in 2015 – the company has been able to depend upon its financial investments to try and fill the gap. As of September 2016, it held $20bn of cash, $47bn of short-term marketable securities and a massive $170bn of long-term marketable securities, including US Treasuries and corporate bonds. In 2016, these generated $4bn of interest and dividend income. In the same year, Apple’s accounts also benefited from an extra $1.6bn of unrealised gains on marketable securities it held.
Apple uses its subsidiary, Braeburn Capital,[1] an asset management company based in the low-tax US state of Nevada, to manage its vast security holdings. These assets rival those of the biggest financial companies, and Braeburn has been called ‘the world’s biggest hedge fund’,[2] and also the world’s biggest bond fund.[3] Another angle on Apple’s operations in this area is shown by considering its financial dealings: in its 2016 year it bought $142bn of marketable securities, received $21bn of funds from those it held that had matured and also sold another $91bn of securities, no doubt keeping Braeburn’s dealers busy.
Compare these numbers to Apple’s investment in research and development. In 2016, it spent $10bn, up from $8bn in 2015 and $6bn in 2014. Big money, and big increases, but still pretty small for a so-called IT company, given that it was less than 5% of total net sales revenue.

Financial derivatives dealing

It is also worth noting Apple’s involvement in financial derivatives to give an example of how all major capitalist corporations use these, not just the supposedly peculiarly evil banks. Apple, like other corporations, uses financial derivatives to hedge against unfavourable moves in interest rates and exchange rates, and also for more speculative purposes. Accounting rules try to separate the two uses, but in reality there is no distinct dividing line.
In the case of derivatives used for hedging, they may make gains or suffer losses. But these should roughly balance the losses or gains on the underlying assets, liabilities or cash flows that are being hedged by the derivatives. For example, if Apple owns a fixed income asset (a corporate or government bond security), then its market price will fall if interest rates rise. However, it could use financial derivatives to hedge against this risk. It would take a derivative position (in swaps, futures or options) whose market price will rise as interest rates rise, so that it would generate a gain in its derivative position to offset the monetary loss on the bond. It is a similar thing for foreign exchange exposures. Simply put, if Apple’s US dollar-based accounts would be hit badly if the value of the US dollar rises against the Chinese renminbi, the euro, or sterling and the Japanese yen, then it makes sense for Apple to hedge the risk with derivative contracts. It would take derivative positions whose value would rise as the dollar’s value rises in the market, thus offsetting, or at least reducing, the potential loss on its underlying business.
The basic idea behind hedging is to offset the likelihood of a loss, but this usually also means giving up on any further potential gains beyond what the existing structure of market prices allows. For example, interest rates or the US dollar’s value might fall, but the extra gains for Apple from these developments will be lowered or eliminated if it hedges against their rise with financial derivatives. The underlying business would gain, but the derivative contracts being used as a hedge would show a loss, cancelling this out.
On 24 September 2016, the notional value of foreign exchange derivatives contracts held by Apple for hedging purposes was $44.7bn. There was also $24.5bn of interest rate contracts. This gives a measure of the scale of the financial risk that was being hedged.
So much for hedging. Speculation with financial derivatives is also a possibility for large corporations. It is one they often use, since their finance departments are commonly seen as profit centres that also have to make a dealing profit in addition to playing their financial function for the firm. Here the word speculation is not used for these derivatives transactions, and they are put under the more polite designation of ‘derivative instruments not designated as accounting hedges’. As of 24 September 2016, Apple held a notional value of $54.3bn of foreign exchange contracts under this heading.
In Apple’s 2016 ‘consolidated statement of comprehensive income’, the accounts record that while it lost $734m on its financial derivatives positions, net of tax, it gained a greater $1,638m in the unrealised extra value of the marketable securities that it held. The balance is not always positive – it was a negative $424m in 2015 – but that’s just one of the risks of dealing in capitalist markets.

Big cash assets, but many liabilities

Apple’s huge cash holdings have gained a lot of attention. Not surprisingly, since at the end of its 2016 financial year it held a little over $20bn in cash and cash equivalents (meaning cash and securities with less than 3 months to maturity), and another $47bn in short-term marketable securities (less than 12 months). The other big chunk of assets held consists of its long-term (more than 12 months) marketable securities, at $170bn. These figures make Apple’s ‘property, plant and equipment’ asset value of $27bn look like a very small part of its overall business. More than six times the value of Apple’s ‘production’ assets is held in financial securities!
But let us not ignore Apple’s various liabilities. An implicit one, an obligation for survival not an accounting item, is the need to keep shareholders happy with dividend payments and share buybacks, as noted above. Then there is Apple’s formal accounting liability resulting from its issuance of debt, valued at $75.4bn on 24 September 2016. These debts have to be serviced and eventually repaid. It also had a ‘non-current’ liability of $36bn (mainly tax that was owed) and total current liabilities of $79bn for accounts payable, accrued expenses, commercial paper outstanding, etc.

Moribund Capitalism

It looks like Apple has a lot of cash available, something that, in another universe, might enable it to reduce its premium prices from their near-absurd levels or to pay more taxes. However, when the full scope of its operations is understood, the constraints of the capitalist market can be clearly seen. Apple’s business is not only one of trying to secure its position in a segment of the consumer technology market. More and more it has become a major financial player, and one that has run out of ideas to develop its formerly core business. Instead it keeps its investors happy with share buybacks and a ‘capital return programme’. It remains the biggest capitalist corporation by market value, although as a monopolistic player it has a lack of incentive to expand production. These features illustrate the moribund nature of contemporary capitalism.

Tony Norfield, 24 May 2017

[1] The name seems to have been chosen because it sounded better than Granny Smith, Cox, or other varieties of apple.

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