Apple’s many magic tricks

By Edward Hadas
April 30, 2014

Apple is in the news for borrowing $12 billion this week, even though it has $151 billion of cash on its balance sheet. The financial legerdemain will keep the technology giant’s tax bill down. It also is suitable for a company whose business model has long looked more like a magic act than a traditional corporate drama.

Of course, Apple has, or had, one of the necessary attributes of any successful enterprise: a strong competitive advantage. The California company’s edge comes from a synergistic mix of design expertise, marketing genius and supply chain mastery.

There is also a bit of technological expertise, but that’s where the magic starts. Apple is a tech star which skimps on the industry’s lifeblood, research and development. The 2.7 percent of revenue dedicated to R&D in the first half of the company’s current fiscal year is puny compared to phone rival Samsung Electronics’ 6 percent-plus and double-digit percentages at Google and Microsoft.

Apple’s trick is to rely on the research of others. Suppliers are crucial to its success. Also, as University of Sussex academic Mariana Mazzucato points out, it efficiently exploits the U.S. government’s valuable work. All tech companies both supply and buy, but Apple somehow manages to transmogrify relatively modest research contributions into relatively large sales and earnings.

Moreover, Chief Executive Tim Cook skips a large portion of the other hard stuff generally associated with industrial companies. Apple doesn’t bother with much manufacturing. It has around 40,000 employees compared with more than a million in its supply chain. It outsources inventory to suppliers too: Apple has only about three days’ worth on its own balance sheet.

Make-or-buy decisions and inventory reduction drives are part of business life. Outsourcing is fashionable and widespread in the tech industry as well as in the garment and toy trades, for instance. Complex global supply chains are the norm these days for complex products. But Apple has taken a standard practice to a whole new level.

For shareholders, the results of this industrial prestidigitation are an impressive 30.5 percent pre-tax profit margin for the six months to March and net income over the past 12 months of $38 billion, a figure that easily tops the total value of property, plant and equipment on the company’s balance sheet. Cook certainly spins a little straw into a lot of gold.

When it comes to finance, Apple is still only an amateur, even after learning some lessons from veteran activist investor Carl Icahn. Holding net cash of more than $120 billion, even after this week’s bond sale, is hardly efficient – especially as major acquisitions are not the company’s style.

But Apple is trying. While eBay, another California success story, said on Tuesday that it has decided to pay the tax needed to bring cash earned abroad into the United States, Apple is doing its best not to pay that price, borrowing to fund its $11 billion annual dividend and its $90 billion buyback plan.

The company has certainly got the hang of the buyback accounting manoeuvre. Share repurchases are counted as a return of capital, even when they clearly aren’t a response to a shrinking business. This unsound classification, though hardly Apple’s choice, pushes up earnings per share, the standard measure of corporate success. Hey, presto: the distribution of a high portion of profits, which is a sign of a lack of corporate opportunity, is changed into an EPS increase, a sign of growth.

Apple’s magic tricks matter.

A shareholder, for one, should have mixed feelings. While the financial returns of Apple’s asset-light approach have been excellent, its reliance on design and marketing almost dooms it to be a niche producer. Rivals with more industrial depth and more willingness to share their expertise will eventually capture most of the market for any product, as Apple has discovered in phones and is learning in tablets.

More fundamentally, there is something disconcerting – perhaps even irresponsible – about a company with a market capitalisation above $500 billion that does not manufacture much of what it sells, does not employ most of the people who make its products, does not pay tax at the full rate and does not tell a perfectly straight story in its financial statements, even if some of that follows from rules not of Apple’s making.

Apple tries to supervise its suppliers and it is always subject to discipline by its customers. Still, in effect, the rich rewards reaped by Apple and its shareholders come in part from leaving to others what used to be considered some of the most fundamental responsibilities of big, high-tech businesses.

From the perspectives of economic efficiency and economic justice, other companies, groups of employees, governments or consumers probably have a better claim than Apple’s shareholders on much of its profit. They also might make better use of the cash, which is too plentiful for Apple to spend wisely.

Of course, Apple isn’t alone in employing some sleight of hand. And it makes real money, not just intangible paper profits. It doesn’t hand egregious amounts of stock to top employees. It’s less aggressive with tax-reducing convolutions than some. And it makes more effort than most to maintain both the image and the reality of good corporate citizenship.

Yet for all this, its magical – or perhaps just post-modern – business model looks like a pretty weak way to support a vital industry.

11 comments

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Excellent in-depth look at Apple’s Magic kingdom. I sometimes wonder whether Apple’s fabled $120 billion in cash still exists, or whether it was lately spent rebuilding Ireland.
It could be that Apple’s devices to hide their profits from the US taxman, by taking advantage of the low corporation tax in Ireland, has become unstuck. As Irish banks are largely bust, and the irish government has assumed their debts, perhaps Apple has been told that they will have to take their place in the queue.

Posted by colebrooke | Report as abusive

Kinda ballsy picking on Apple. Lots of fanboys will attack you. I like it!

Posted by tmc | Report as abusive

“there is something disconcerting – perhaps even irresponsible – about a company with a market capitalisation above $500 billion that does not manufacture much of what it sells, does not employ most of the people who make its products”

Do Walmart, Sears, Costco, etc manufacture what they sell or employ most of the people who make their products? When it comes to disconcerting behavior, what about the American governments claim to 35% of Apple profits that are generated from the sale of Apple products designed by foreigners; built in foreign factories by foreign workers and then sold to other foreigners in foreign countries?

Posted by walstir | Report as abusive

“there is something disconcerting – perhaps even irresponsible – about a company with a market capitalisation above $500 billion that does not manufacture much of what it sells, does not employ most of the people who make its products”

Do Walmart, Sears, Costco, etc manufacture what they sell or employ most of the people who make their products? When it comes to disconcerting behavior, what about the American governments claim to 35% of Apple profits that are generated from the sale of Apple products designed by foreigners; built in foreign factories by foreign workers and then sold to other foreigners in foreign countries?

Posted by walstir | Report as abusive

apple parasitica; genus–> malus, species–> supersuckerum domestica

Posted by satori23 | Report as abusive

Apple business model works, but I guess the author missed that.

On the foreign tax bit, clearly the US needs to abandon the notion of letting US companies hide profits overseas. Apple was not one of the companies originally lobbying to create that loophole, but they use it.

On the research percentages: Apple creates great new innovative products with 2.7%. Microsoft spends more than 10% and gets absolutely nothing original for it. Microsoft has bought or copied every technology it sells since Bill Gates stopped personally writing code.

Posted by QuietThinker | Report as abusive

@QuietThinker, yes it works, but you must admit that if it spread to the majority of American corporations it would severely hurt our economy. Many more jobs would be lost and vast amounts of capital would flow out of the country. They would have basically killed the goose that laid the golden egg (the middle class). I don’t think China and India are going to give up their markets to them either. They’re not that stupid.

Posted by tmc | Report as abusive

@UTC I half agree with you. I think that the off-shoring part of the Apple business model severely hurts the U.S. I am 100% for eliminating the tax incentives for shipping jobs overseas. I do understand the need for global companies so I would not kill incentives for doing business abroad. I would force repatriation and taxation of some significant percentage (25%, 50%?) of cumulative untaxed profits held abroad for any tax year in which a company failed to increase its US payroll as measured by Social Security taxes paid. I would use Social Security taxes to avoid megasalaries to corporate officers counting as payroll.

On the other hand, Apple is clearly doing a stellar job of product creation. If only other companies could pick up on that, we would have a tremendous boost to the economy. That part of their business model I love.

Posted by QuietThinker | Report as abusive

Oops I meant to type @TMC above, not @UTC.

Posted by QuietThinker | Report as abusive

It seems we’re much closer in opinion then. I too was very impressed by Apples ability to innovate being a mega-corporation and all. But that was the uniqueness of Steve Jobs. I highly doubt that Apple will be able to maintain that. They couldn’t without him before.
I also agree that we need global trade. I just think our corporate world has lost all morals and ethics and definitely lost any sense of patriotism to the US. I guess that’s to be expected in a global economy though. It’s not just happening to us, but all countries. If only the transition were more smooth.

Posted by tmc | Report as abusive

Apple has only been a world leader in its market sector since the introduction of the iPhone in 2007 – 7 years ago. Since then, of course, everything’s come up roses. The intro of the iPod in 2001 breathed life into the nearly DOA corporation that made great stuff without being able to sell enough of the darn things. I’d give it some time to settle in and just do what it has always done best: manufacture well-deisgned pricey consumer tech devices (and it used to do that itself, in the U.S. when the supply chain was here, which it isn’t and which is not the fault of Apple). This market sector is in its infancy. All the leading tech device manufacturers are in the same boat, some are rowing and some are enjoying the view.

Posted by timebandit | Report as abusive