Behind Apple's Tax Situation, an Unprecedented Financial Policy

The European Union recently hit Apple with a $14.5 billion tax bill, but that’s hardly the first or worst financial challenge the technology giant has faced. In 1997, the company suffered a near-death experience that caused it to completely reimagine itself. The result was a new line of products and an unprecedented financial model. Mihir Desai explains the financial wiring behind the inventors of the iPhone.

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Podcast Transcript

Brian Kenny: In 1997, well before tablets and smart phones, Apple co-founder Steve Jobs shocked the standing-room-only crowd at Macworld Boston by announcing that archrival Microsoft was about to become the company savior. The announcement followed 18 consecutive months of losses at Apple, leaving the company just weeks away from insolvency. Microsoft's $150 million investment pulled Apple from the brink. Fast-forward to 2015, and Apple was the twelfth-largest public company in the world, with a market value of $742 billion. Microsoft ranked 25th. Today, we'll hear from Professor Mihir Desai about his case entitled "Financial Policy at Apple, 2013." I'm your host, Brian Kenny, and you're listening to Cold Call.

Mihir Desai teaches in the MBA, doctoral, and executive programs at Harvard Business School, and he's an expert in tax policy and international finance, and corporate finance, all of which matter in this case. Mihir, thanks for joining me.

Mihir Desai: Thanks so much, Brian. It's a pleasure to be here.

Kenny: I'll start the way that I normally start these, which is to ask you to set the case up for us. What's the opening?

Desai: It's a terrific situation at Apple in 2013. They are obviously very successful by most measures. On the product side, they're very successful. It turns out they're facing incredible capital markets pressure. The firm has been doing very, very well but cash has been piling up at Apple in a way that is remarkable—hundreds of billions of dollars are piling up inside the corporation and shareholders are starting to get angry; two shareholders in particular, David Einhorn and Carl Icahn, are protesting. They're saying, “Give us the cash.” They're saying it loudly and they're saying it more and more loudly. Cook and Jobs have to really think through whether or not to give them the cash, and if so, how. It's a great story about an iconic corporation being pushed by capital markets to change the way they think about finance.

Kenny: The protagonist here is none other than Cook, himself.

Desai: Exactly. He's got to figure out whether the policy that Jobs had, which was effectively to say, “Okay, shareholders, whatever, we take care of the cash, don't bother us too much.” Pressure's been rising and Cook, obviously, at that time didn't have the stature that Jobs had.

Kenny: We should say that sitting on a pile of cash is a first world problem to have.

Desai: It is a first world problem to have. It's a high-class problem, but a problem nonetheless, as they say. It turns out that the shareholders were getting angry enough to start floating proposals that, “We will issue these securities and you'll be able to give us the cash in this way.” Cook can no longer ignore them.

Kenny: What prompted you to write this case? Why did you settle on this as a case to write?

Desai: I was struck by a number of developments in the capital markets, and I think Apple's situation is paradigmatic of something that's going on that's much larger. That larger trend that is happening is large amounts of cash inside corporations, increasing pressure to disgorge that cash, management feeling pressure to do that via dividends and share repurchases. We are now living in an age that I like to characterize as a slow-motion LBO of America. Which is, it's an age characterized by borrowing and by buying back shares. Apple, a remarkably successful company, gets pushed into that same trend. Over the time period since the case, they have effectively levered up and bought back an enormous amount of shares. I thought it was representing something very big that's happening in capital markets. Then of course, anything with Apple is just enormous amounts of fun.

Kenny: Yeah, such a well-known brand. Did you spend time there, were you actually in the Apple offices?

Desai: Well, so I went, after I wrote the case. I don't think Apple has ever cooperated with the case. After I wrote the case, they called me, and I went out there and I talked to a bunch of folks there. It was really interesting and really fun. They're quite tight-lipped on these questions.

Kenny: Apple, as successful as they have been in the last two decades—which is remarkable, the amount of success that they've had—they haven't always been successful. They've had some struggles. Can you tell our listeners the kinds of challenges they face? Because I think it's ancient history. There's a whole generation that's grown up not knowing about this.

Desai: Right. Twenty years ago, it turns out to be ancient history. That's absolutely right. From near bankruptcy, they get saved and then they become this company which starts developing products that are iconic, beginning with, of course, the iPod and then moving into the phone and then the tablets. During that time, they both become iconic for product reasons, which I think most people understand, but the first part of the case discussion that we have with this case is you get to understand how they are not just remarkable from products. They are remarkable financially. There is a financial model embedded in Apple that is incredible, which probably stems from that near-death experience.

For example, their profitability is remarkable. Their growth is remarkable. That isn't that surprising. You look a little deeper and you realize, they are a cash flow machine. They run a working capital cycle like you wouldn't believe. They are asset-light in a remarkable way. They are effectively operating with zero net assets. They are borrowing from and being financed, effectively, by their suppliers. These folks are doing something financially which is very novel and makes the economic model they have even more powerful than just making great products, and making great profits. They turned out to have a huge cash flow machine running that is, I think, unprecedented.

Kenny: You talk in the case a little bit about their tax structure too. I know this is something that you've spoken about, even on Capitol Hill, the idea of repatriation of taxes. Can you talk a little bit about that?

Desai: Sure. The other piece here is this cash that has been piling up. One of the reasons is that it's mostly in Ireland. At the time of the case, $90 to $120 billion of it is in Ireland, and the reason it's in Ireland is those are the profits from all around the world that have been funneled to Ireland, which pay basically zero tax. The issue is, why is it still in Ireland? The answer, of course, is the U.S. says, “If you bring it back to the U.S., we will tax you at our tax rate.”

In fact, one of the great things about this case happened right around that same time. Tim Cook gets called to the Senate to testify, which says, “What are you doing? Why aren't you bringing back your 100 billion dollars?” Because after the case gets resolved, he actually borrows money to do all these payouts, and the Senators are not terribly happy. It leads to this fantastic scene, because Tim Cook goes to the Senate and he testifies, and it's a wonderful scene because all the Senators are there. You're expecting a big interrogation and the first thing, of course, that happens is the Senators ask him how to use their iPhones. And then they proceed to interrogate him. Cook says, very clearly, “You fix your policy, and I'll bring back the cash. Why would I bring back my cash and pay a 35% rate when I can borrow in the capital markets at 2%?” Cook really played it hard. His point was, “We are the largest American taxpayer. We pay all our American taxes.”

Kenny: 16 million a day, I think, is what they said.

Desai: It's remarkable numbers. He basically says, “Look, these are profits that are effectively from products we sold in Germany, and China, and India. It's not clear why you should be concerned. If you figure out your policy problems….” As you know, the U.S. tax system on foreign income has become the subject of a remarkable amount of contentions, leading to mergers and acquisitions that don't make sense. It's leading to a lot of big problems. Apple's decision to become the largest borrower in capital markets after the case reflects the fact that now dominant transactions in the M&A market, and the capital markets, are being driven by tax considerations.

Kenny: How did they get so good at this? They're just a company that makes products and devices and things?

Desai: Well, it is interesting, right? I think there's two things to say. One is, they, and Tim Cook in particular of course, has been a supply chain person. They quickly understood the power of a really good supply chain. That leads to this economic model that is remarkable. A. Your suppliers are so happy to be doing business with you that they're willing to finance you. They're willing to hold all your inventory. It turns out this large retailer, one of the largest retailers in the world, has three days of inventory. No retailer operates with three days of inventory. That leads to this remarkable cash conversion cycle.

I think it was embedded in the idea of doing supply chain in the way they did that they would also have this remarkable cash flow characteristic associated with it. Then the asset intensity as well. Going back to your original question, Brian, I think there is something about near-death experiences which change the way you operate. They are tough, and they operate financially in a very savvy way. To me, when I've gone out there it's been remarkable. Senior management is involved in many, many financial decisions at a micro level. They run a very tight ship despite the fact that they're swimming in cash and swimming in profits. It's a very disciplined company in that way.

Kenny: I think it also shines a light a little bit on the decision to put Tim Cook into that job after Steve Jobs left. He was such a cult of personality and I think the question was always, “Who could possibly replace him?” Tim is a very different type of leader, but clearly somebody who they sought out for a very specific reason.

Desai: Yes, I think this is something that we see in other companies too. Amazon has a similar cash flow model. Dell, of course, does. They don't like to talk about it too much, because they want to talk about the customer. Underneath it all, these companies are very prominent because they're taking market share in dramatic ways, but they have an economic model that allows them to finance their growth in very effective ways. There's a whole capital market strategy there. Bezos and Amazon is another good example of it. They quote unquote “don't make any profits,” except they make a ton of cash. They make it mostly from their suppliers. That is a really—it's a whole different model that I think is emerging.

Kenny: Interesting. Well, let's get back to the drama of this case because I think really where the tension comes is when the activist shareholders get involved. This is something that we're seeing play out, really, in many different sectors.

Desai: Absolutely.

Kenny: Let's talk about how it was playing out in this case.

Desai: It's playing out here as it is all over the economy, which is large activist shareholders taking stakes and then pressuring, in this particular case, for the disgorging of cash. In a way, that's what's fun about this case, because you would think, “Who would take on Apple?” Sure enough, there's somebody who's willing to do it, and they did it very effectively. In part, what they did is they took a stake. The larger thing they did is they floated a proposal and it had all the bells and whistles that you would expect. For example, it was called an iPref. They even put an “i” in front just to make sure.

Kenny: Yes, a lower case i.

Desai: A lower case “i”, to make sure everybody got the idea that Apple should issue a new security which would effectively allow them to disgorge all this cash in a tax efficient way. By drawing attention to it, this cash hoard, they kind of compelled ultimately Cook to do something. David Einhorn held a large press conference. He said, “Here, we've got to do this iPref, and it will unlock almost close to $150 a share when the share price was $450.” He had a big claim that if we just did this, it would work. Of course, underneath it all, he's really just trying to draw attention to this cash hoard and get them to start distributing it in dividends and repurchases.

Kenny: Right. What was Apple's reaction to that proposal?

Desai: One of the nice things in the case is it traces the reactions over several conference calls. The first conference call, Apple's pretty tough. They're like, “We get to do what we want with the cash.” The second conference call, the questions become a little more insistent. The third conference call, the questions are becoming more insistent, like, “Where's the cash?”

Initially, they rebuffed it and they never directly addressed it. Of course, ultimately what happens at the end of the case is Apple buckles. They become one of the largest dividend payers and one of the largest share re-purchasers in history. It's all funded by some of the largest capital markets borrowings in history. I think you're right, it highlights this larger pressure on firms to satisfy activists and disgorge cash in very large ways, which can be fantastic news or could be quite destructive news.

Kenny: You've taught this case in class?

Desai: I have, several times. It's enormous fun. It goes in a really nice way, which is the first part is just to have people realize that there's a financial model underneath the products. It's just kind of an appreciation for, “God, this is what they built.” The second part is, why are they sitting on so much cash? Then you get to see this cash machine and you get to see the asset intensity of the business. Then the question becomes, “Well, how much cash could they disgorge?” It turns out, under even like worst-case scenarios, because some people think, well, we have to hold cash because something bad could happen.

Kenny: Right, well, you need the capacity to innovate. We hear that all the time.

Desai: Exactly right, although that logic becomes less clear when you're holding $200 billion of cash. The exercise we run through is, well, let's say they don't sell anything for two years, which is an absurd example. They can still disgorge, they can still run the company for two years if they, and they can still disgorge $80 billion of cash.

The second exercise is, having disgorged all that cash, they are going to build it back up in about four years. There's just this enormous feeling that, “God, actually we could disgorge it. We could do it really effectively.” Then the final part is this dividend and share repurchase and iPref comparison. It's an opportunity to think about capital distributions, cash distribution policy, and why the iPref thing that David Einhorn does is a little bit of smoke and mirrors. Why, even if it is smoke and mirrors, it might be effective because people all of a sudden say, “Hey, that is a lot of cash they're sitting on, and why aren't they giving it back to us?” His logic is kind of flawed, and I'm sure he knew that, it was a little smoke and mirrors, but he ends up kind of succeeding just by shining a light and pressuring them to do what he is asked them to do.

Kenny: I think every CEO should run out and get a copy of this case.

Desai: I'm all for that.

Kenny: Thank you, Mihir, for joining us.

Desai: It's my pleasure.

Kenny: You can find this case, along with thousands of others, in the Harvard Business School case collection at HBR.org. I'm Brian Kenny. Thanks for listening to Cold Call, the official podcast of Harvard Business School.

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Podcast Transcript

Brian Kenny: In 1997, well before tablets and smart phones, Apple co-founder Steve Jobs shocked the standing-room-only crowd at Macworld Boston by announcing that archrival Microsoft was about to become the company savior. The announcement followed 18 consecutive months of losses at Apple, leaving the company just weeks away from insolvency. Microsoft's $150 million investment pulled Apple from the brink. Fast-forward to 2015, and Apple was the twelfth-largest public company in the world, with a market value of $742 billion. Microsoft ranked 25th. Today, we'll hear from Professor Mihir Desai about his case entitled "Financial Policy at Apple, 2013." I'm your host, Brian Kenny, and you're listening to Cold Call.

Mihir Desai teaches in the MBA, doctoral, and executive programs at Harvard Business School, and he's an expert in tax policy and international finance, and corporate finance, all of which matter in this case. Mihir, thanks for joining me.

Mihir Desai: Thanks so much, Brian. It's a pleasure to be here.

Kenny: I'll start the way that I normally start these, which is to ask you to set the case up for us. What's the opening?

Desai: It's a terrific situation at Apple in 2013. They are obviously very successful by most measures. On the product side, they're very successful. It turns out they're facing incredible capital markets pressure. The firm has been doing very, very well but cash has been piling up at Apple in a way that is remarkable—hundreds of billions of dollars are piling up inside the corporation and shareholders are starting to get angry; two shareholders in particular, David Einhorn and Carl Icahn, are protesting. They're saying, “Give us the cash.” They're saying it loudly and they're saying it more and more loudly. Cook and Jobs have to really think through whether or not to give them the cash, and if so, how. It's a great story about an iconic corporation being pushed by capital markets to change the way they think about finance.

Kenny: The protagonist here is none other than Cook, himself.

Desai: Exactly. He's got to figure out whether the policy that Jobs had, which was effectively to say, “Okay, shareholders, whatever, we take care of the cash, don't bother us too much.” Pressure's been rising and Cook, obviously, at that time didn't have the stature that Jobs had.

Kenny: We should say that sitting on a pile of cash is a first world problem to have.

Desai: It is a first world problem to have. It's a high-class problem, but a problem nonetheless, as they say. It turns out that the shareholders were getting angry enough to start floating proposals that, “We will issue these securities and you'll be able to give us the cash in this way.” Cook can no longer ignore them.

Kenny: What prompted you to write this case? Why did you settle on this as a case to write?

Desai: I was struck by a number of developments in the capital markets, and I think Apple's situation is paradigmatic of something that's going on that's much larger. That larger trend that is happening is large amounts of cash inside corporations, increasing pressure to disgorge that cash, management feeling pressure to do that via dividends and share repurchases. We are now living in an age that I like to characterize as a slow-motion LBO of America. Which is, it's an age characterized by borrowing and by buying back shares. Apple, a remarkably successful company, gets pushed into that same trend. Over the time period since the case, they have effectively levered up and bought back an enormous amount of shares. I thought it was representing something very big that's happening in capital markets. Then of course, anything with Apple is just enormous amounts of fun.

Kenny: Yeah, such a well-known brand. Did you spend time there, were you actually in the Apple offices?

Desai: Well, so I went, after I wrote the case. I don't think Apple has ever cooperated with the case. After I wrote the case, they called me, and I went out there and I talked to a bunch of folks there. It was really interesting and really fun. They're quite tight-lipped on these questions.

Kenny: Apple, as successful as they have been in the last two decades—which is remarkable, the amount of success that they've had—they haven't always been successful. They've had some struggles. Can you tell our listeners the kinds of challenges they face? Because I think it's ancient history. There's a whole generation that's grown up not knowing about this.

Desai: Right. Twenty years ago, it turns out to be ancient history. That's absolutely right. From near bankruptcy, they get saved and then they become this company which starts developing products that are iconic, beginning with, of course, the iPod and then moving into the phone and then the tablets. During that time, they both become iconic for product reasons, which I think most people understand, but the first part of the case discussion that we have with this case is you get to understand how they are not just remarkable from products. They are remarkable financially. There is a financial model embedded in Apple that is incredible, which probably stems from that near-death experience.

For example, their profitability is remarkable. Their growth is remarkable. That isn't that surprising. You look a little deeper and you realize, they are a cash flow machine. They run a working capital cycle like you wouldn't believe. They are asset-light in a remarkable way. They are effectively operating with zero net assets. They are borrowing from and being financed, effectively, by their suppliers. These folks are doing something financially which is very novel and makes the economic model they have even more powerful than just making great products, and making great profits. They turned out to have a huge cash flow machine running that is, I think, unprecedented.

Kenny: You talk in the case a little bit about their tax structure too. I know this is something that you've spoken about, even on Capitol Hill, the idea of repatriation of taxes. Can you talk a little bit about that?

Desai: Sure. The other piece here is this cash that has been piling up. One of the reasons is that it's mostly in Ireland. At the time of the case, $90 to $120 billion of it is in Ireland, and the reason it's in Ireland is those are the profits from all around the world that have been funneled to Ireland, which pay basically zero tax. The issue is, why is it still in Ireland? The answer, of course, is the U.S. says, “If you bring it back to the U.S., we will tax you at our tax rate.”

In fact, one of the great things about this case happened right around that same time. Tim Cook gets called to the Senate to testify, which says, “What are you doing? Why aren't you bringing back your 100 billion dollars?” Because after the case gets resolved, he actually borrows money to do all these payouts, and the Senators are not terribly happy. It leads to this fantastic scene, because Tim Cook goes to the Senate and he testifies, and it's a wonderful scene because all the Senators are there. You're expecting a big interrogation and the first thing, of course, that happens is the Senators ask him how to use their iPhones. And then they proceed to interrogate him. Cook says, very clearly, “You fix your policy, and I'll bring back the cash. Why would I bring back my cash and pay a 35% rate when I can borrow in the capital markets at 2%?” Cook really played it hard. His point was, “We are the largest American taxpayer. We pay all our American taxes.”

Kenny: 16 million a day, I think, is what they said.

Desai: It's remarkable numbers. He basically says, “Look, these are profits that are effectively from products we sold in Germany, and China, and India. It's not clear why you should be concerned. If you figure out your policy problems….” As you know, the U.S. tax system on foreign income has become the subject of a remarkable amount of contentions, leading to mergers and acquisitions that don't make sense. It's leading to a lot of big problems. Apple's decision to become the largest borrower in capital markets after the case reflects the fact that now dominant transactions in the M&A market, and the capital markets, are being driven by tax considerations.

Kenny: How did they get so good at this? They're just a company that makes products and devices and things?

Desai: Well, it is interesting, right? I think there's two things to say. One is, they, and Tim Cook in particular of course, has been a supply chain person. They quickly understood the power of a really good supply chain. That leads to this economic model that is remarkable. A. Your suppliers are so happy to be doing business with you that they're willing to finance you. They're willing to hold all your inventory. It turns out this large retailer, one of the largest retailers in the world, has three days of inventory. No retailer operates with three days of inventory. That leads to this remarkable cash conversion cycle.

I think it was embedded in the idea of doing supply chain in the way they did that they would also have this remarkable cash flow characteristic associated with it. Then the asset intensity as well. Going back to your original question, Brian, I think there is something about near-death experiences which change the way you operate. They are tough, and they operate financially in a very savvy way. To me, when I've gone out there it's been remarkable. Senior management is involved in many, many financial decisions at a micro level. They run a very tight ship despite the fact that they're swimming in cash and swimming in profits. It's a very disciplined company in that way.

Kenny: I think it also shines a light a little bit on the decision to put Tim Cook into that job after Steve Jobs left. He was such a cult of personality and I think the question was always, “Who could possibly replace him?” Tim is a very different type of leader, but clearly somebody who they sought out for a very specific reason.

Desai: Yes, I think this is something that we see in other companies too. Amazon has a similar cash flow model. Dell, of course, does. They don't like to talk about it too much, because they want to talk about the customer. Underneath it all, these companies are very prominent because they're taking market share in dramatic ways, but they have an economic model that allows them to finance their growth in very effective ways. There's a whole capital market strategy there. Bezos and Amazon is another good example of it. They quote unquote “don't make any profits,” except they make a ton of cash. They make it mostly from their suppliers. That is a really—it's a whole different model that I think is emerging.

Kenny: Interesting. Well, let's get back to the drama of this case because I think really where the tension comes is when the activist shareholders get involved. This is something that we're seeing play out, really, in many different sectors.

Desai: Absolutely.

Kenny: Let's talk about how it was playing out in this case.

Desai: It's playing out here as it is all over the economy, which is large activist shareholders taking stakes and then pressuring, in this particular case, for the disgorging of cash. In a way, that's what's fun about this case, because you would think, “Who would take on Apple?” Sure enough, there's somebody who's willing to do it, and they did it very effectively. In part, what they did is they took a stake. The larger thing they did is they floated a proposal and it had all the bells and whistles that you would expect. For example, it was called an iPref. They even put an “i” in front just to make sure.

Kenny: Yes, a lower case i.

Desai: A lower case “i”, to make sure everybody got the idea that Apple should issue a new security which would effectively allow them to disgorge all this cash in a tax efficient way. By drawing attention to it, this cash hoard, they kind of compelled ultimately Cook to do something. David Einhorn held a large press conference. He said, “Here, we've got to do this iPref, and it will unlock almost close to $150 a share when the share price was $450.” He had a big claim that if we just did this, it would work. Of course, underneath it all, he's really just trying to draw attention to this cash hoard and get them to start distributing it in dividends and repurchases.

Kenny: Right. What was Apple's reaction to that proposal?

Desai: One of the nice things in the case is it traces the reactions over several conference calls. The first conference call, Apple's pretty tough. They're like, “We get to do what we want with the cash.” The second conference call, the questions become a little more insistent. The third conference call, the questions are becoming more insistent, like, “Where's the cash?”

Initially, they rebuffed it and they never directly addressed it. Of course, ultimately what happens at the end of the case is Apple buckles. They become one of the largest dividend payers and one of the largest share re-purchasers in history. It's all funded by some of the largest capital markets borrowings in history. I think you're right, it highlights this larger pressure on firms to satisfy activists and disgorge cash in very large ways, which can be fantastic news or could be quite destructive news.

Kenny: You've taught this case in class?

Desai: I have, several times. It's enormous fun. It goes in a really nice way, which is the first part is just to have people realize that there's a financial model underneath the products. It's just kind of an appreciation for, “God, this is what they built.” The second part is, why are they sitting on so much cash? Then you get to see this cash machine and you get to see the asset intensity of the business. Then the question becomes, “Well, how much cash could they disgorge?” It turns out, under even like worst-case scenarios, because some people think, well, we have to hold cash because something bad could happen.

Kenny: Right, well, you need the capacity to innovate. We hear that all the time.

Desai: Exactly right, although that logic becomes less clear when you're holding $200 billion of cash. The exercise we run through is, well, let's say they don't sell anything for two years, which is an absurd example. They can still disgorge, they can still run the company for two years if they, and they can still disgorge $80 billion of cash.

The second exercise is, having disgorged all that cash, they are going to build it back up in about four years. There's just this enormous feeling that, “God, actually we could disgorge it. We could do it really effectively.” Then the final part is this dividend and share repurchase and iPref comparison. It's an opportunity to think about capital distributions, cash distribution policy, and why the iPref thing that David Einhorn does is a little bit of smoke and mirrors. Why, even if it is smoke and mirrors, it might be effective because people all of a sudden say, “Hey, that is a lot of cash they're sitting on, and why aren't they giving it back to us?” His logic is kind of flawed, and I'm sure he knew that, it was a little smoke and mirrors, but he ends up kind of succeeding just by shining a light and pressuring them to do what he is asked them to do.

Kenny: I think every CEO should run out and get a copy of this case.

Desai: I'm all for that.

Kenny: Thank you, Mihir, for joining us.

Desai: It's my pleasure.

Kenny: You can find this case, along with thousands of others, in the Harvard Business School case collection at HBR.org. I'm Brian Kenny. Thanks for listening to Cold Call, the official podcast of Harvard Business School.

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