When I wrote suggesting that the “best use of cash” was not acquisition but integration of manufacturing under the Apple control umbrella, the rumor that set off that discussion was that Apple was financing new facilities for its suppliers.
Those rumors were quashed, but we now know there is something to them.
During the September and December quarters, we executed long-term supply agreements with three vendors through which we expect to spend a total of approximately $3.9 billion in inventory component prepayments and capital expenditures over a two-year period. We made approximately $650 million in payments under these agreements in the December quarter, and anticipate making $1.05 billion in payments in the March quarter.
Apple Management Discusses F1Q11 Results – Earnings Call Transcript – Seeking Alpha [my emphasis]
So Peter Oppenheimer confirmed that Apple is using its cash as a loan facility for its manufacturing partners. It’s not for the first time either. Apple used the same leverage to ensure the supply of flash memory for the iPod line in 2005.
Philip Elmer-DeWitt reminds us Tim Cook confirmed:
The deal, he said, is similar to the one Apple cut five years ago:
“As you probably remember,” he began, “we signed a deal with several flash [memory chip] suppliers back at the end of 2005 that totaled over $1 billion because we anticipated that flash would become increasingly important across our entire product line and increasingly important to the industry. And so we wanted to secure supply for the company.
Partly as a result was a dominant position in the music player market that is still paying off today.
The use of capital to pre-pay for production is not therefore new. What we saw last quarter however is that it’s using capital to ensure there is additional capacity.
In other words, Apple Inc. pre-buys additional capacity by using Bank of Apple capital as a loan facility to bring more capacity online. How to judge this use of capital depends on your perspective:
- From a fiscal perspective, Apple is acting like a trade lender (with moderate to low returns on capital.)
- From the operational perspective Apple is acting as a limited manufacturing partner, just short of an equity holder.
- From a strategic perspective, the Bank of Apple lends only to suppliers that commit to producing for Apple Inc. Thus locking out competitors.
This strategy is not without risk. Those loans are forward contracts on production. The risk is that production is unneeded and hence the loans won’t be “paid back”. But Apple knows demand and supply in this market better than anyone else, so it has an unfair advantage over the market. So the rewards are probably out of proportion to the risk.
By buying an option on production, not production itself Apple has a clever way to “own factories” without actually owning them: gain control over marginal increase in production without the impact from CapEX or depreciation.
The return on that option will never be seen on the OI&E line in the income statement and the cash once recycled back into the balance sheet will seem to be sitting unrewarded. But the return on that capital will show up in the bottom line by way of margin and top line expansion for years to come.
The committed capital is still tiny, but a proper analysis of Apple’s cash management would be to look at the return on cash as more than the return on treasury bills.