When one thinks about what Apple’s (AAPL, Financial) business is, the initial answer is obvious: It makes amazing tech products like the iPhone, MacBook and Apple Watch, supported by wonderfully user-friendly software and online services.
Yet that conventional view of Apple conceals a whole other business, one that is largely separate from the ordinary development, manufacturing and sales operations with which we are all familiar. And it is massive.
What is this unknown other business?
It is Apple’s financial arm and is, by some measures, half the size of investment banking giant Goldman Sachs (GS, Financial). Dubbed “Apple Capital” by The Economist, Apple’s financial and investment operation has more than $260 billion in assets and carries more than $100 billion in debt. That is a huge investment footprint, one that is especially remarkable for the lack of attention paid to it.
What exactly is Apple Capital?
Apple’s financial arm is not one business unit. Its operations are scattered across disparate departments and subsidiaries. One is Braeburn Capital, an asset management firm tasked with placing a large chunk of Apple’s excess profits into relatively safe securities, as well as making allocation decisions to other asset managers. On its own, Apple has issued billions of dollars’ worth of floating-rate bonds. It has also grown increasingly involved in derivatives, which it uses principally to hedge against interest rate and currency risks, important for a company with operations sprawled across the globe.
Why haven’t I heard of it?
Apple investors and analysts tend to be focused exclusively, or at least principally, on earnings and growth in the company’s core business. That is understandable, considering the fact that it has been revenues from sales that have created the vast piles of cash now filling Apple’s coffers. And Apple has lightened its cash pile somewhat by returning more than $220 billion to shareholders. These considerations – operating revenues, margins, sales growth, share buybacks, etc. – are what consume analyst interest, hogging the focus of investment notes and earnings call discussions. But the financial operation is becoming increasingly dangerous to ignore.
Does Apple Capital really matter?
Yes. As The Economist reported in October 2017, Apple’s financial arm has been growing rapidly with no sign of abating:
“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.”
That is a huge piece of Apple as a company, and its influence is only set to grow. For investors buying Apple shares to enjoy the boons of greater earnings through sales of Apple products and services, the position of a vast and growing financial arm presents sticky questions.
What’s the problem?
There are several. For one thing, even as Apple’s financial activities take on an ever increasing influence on the company as whole, they have no central control or overarching strategy. While Apple used to invest its cash hoard in relatively safe, low-return assets, it has lately been hunting yield through allocation to higher risk securities. That exposes the company's sprawling investment portfolio to market reversals, which could prove disastrous to the parent if things go sour.
Has this ever happened before?
Few things in life or markets are truly unprecedented, and Apple’s piecemeal accumulation of a financial empire is no exception. Indeed, General Electric’s (GE, Financial) financial arm, GE Capital, charted a similar trajectory. It started out as a relatively small financing subsidiary, only to balloon in size in the years before the financial crisis. When the crisis hit, it wrecked GE Capital and threw a heavy lodestone around the neck of its parent. The burdens of untangling itself from GE Capital’s transgressions still linger. Indeed, GE this month announced a $6.2 billion charge as part of its continued efforts to clean up the mess of its once over-mighty finance unit.
Could it happen at Apple?
Apple’s financial arm does not make loans, so it is not likely to suffer the same sort of disaster that sank GE Capital. However, a ballooning derivatives book and increasing exposure to high-risk assets is setting the stage for a potential blow-up of its own. A crash in its financial asset, given its leveraged exposure, could hobble the company and force the diversion of operating earnings to plug holes and clean up messes. Markets would not be at all pleased in such an eventuality. It could permanently damage Apple’s reputation, even if it succeeded in closing up its financial wounds.
What should Apple do?
Apple cannot afford to be complacent. As the current bull market persists in sending asset prices to unprecedented levels, and across virtually all asset classes, the prospects of a nasty correction become ever more dangerous. The first thing Apple should do is centralize its disparate financial operations under a single strategic and operational control. Then it should start winding down its risky positions.
Apple must take action before events force its hand. Much better to seize the initiative now, while it can still book profits from its multifarious investments.
Disclosure: I/We own no stocks mentioned in this article.
