risk that Apple Inc. faces with respect to its international economic exposure. Apple designs its products in the United States, manufactures them in China and then sells them all over the world. In order to analyze this exposure, a number of steps will be undertaken. The first step will be to provide an overview of the business, what its foreign exchange exposure is, and how the company manages that foreign exchange rate risk. The subsequent sections will discuss the degree of exposure that the company has to other forms of international risk — economic risk in particular. There will be an industry and company analysis to provide a framework for this discussion of risk. There is also going to be a discussion of how the company manages the different risks to which it is exposed, and what the analysts’ views of this exposure are as well. The final component of this report will consist of a scenario analysis, wherein Apple’s business will be evaluated for robustness in best-, worst- and most likely-case scenarios. Conclusions will be drawn from all of this research and analysis with respect to how well Apple is managing its international risk.
Foreign Exchange Rate Risk
Foreign exchange rate risk is defined as the risk that arises from the fluctuations in foreign exchange rates vs. The home currency. There are two forms of foreign exchange rate risk, transactional and translational. Translational risk arises when the company exchanges currencies. The company typically will either gain on these transactions or lose, depending on which direction the currency has moved. The volatility of these currency movements is where the risk arises. Translational risk occurs in translating back foreign earnings to the home country income statement. This type of risk is more difficult to hedge and therefore is often not addressed by companies. This report will focus on transactional risk.
Apple’s foreign currency risk mainly arises from the goods it sells, but there is also some indirect risk that it faces with its suppliers. The direct risk arises when selling in foreign markets, with the price of goods denominated in foreign currencies. At the retail level, Apple aims to achieve pricing parity worldwide — the price of an Apple product in a foreign currency will be the equivalent of that product’s USD price on the domestic market. The company therefore is exposed to risk when it attempts to repatriate earnings from foreign countries back to the United States. There is significant exposure to the pound, the euro, the yen, CAD, AUD, HKD, SGD, as well as the won and yuan. Exposure to Asia-Pacific currencies has increased significantly in recent years. Since the company is especially susceptible to gains in the USD, the currencies most at risk are ones that are prone to weakness against the USD – in recent the years the macroeconomic situations make the EUR, GBP and JPY the most at-risk currencies; the CAD, yuan and AUD are among the less at-risk currencies that are generally appreciating against the USD.
In the Form 10-K, Apple specifically mentions that it “uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures in foreign currency exchange rates” (p.19). The company also noted that in 2011 it faced higher premium expenses on such hedges. Under Item 7A (p.40), the company notes that it “regularly reviews its foreign exchange forward and option positionsâ€¦in conjunction with its underlying foreign currency and interest rate exposures.” The company notes that it is a “net receiver of currencies other than the U.S. dollar” and therefore is particularly prone to strengthening of the U.S. dollar. The company also notes that it might at some point be forced to adjust local currency pricing in response to significant volatility in foreign currency exchange rates. Apple normally hedges its positions for up to six months, and chooses only to hedge certain exposures, leaving other unhedged (p.40). The company does not specify the reasons it does this. There is also a degree of indirect exposure in terms of the economic conditions under which its suppliers operate. While Apple pays its suppliers in dollars, its suppliers typically pay their expenses in yuan, and inflation in China can dramatically affect the ability of Apple suppliers to meet the prices the company sets profitably. There is risk that these pressures will affect Apple’s ability to bring its products to market at the price points it wishes to set.
In general, Apple’s foreign exchange rate management program is in line with industry norms. The company understands its exposure specifically, and takes steps to measure that exposure and address it through a variety of hedging mechanisms. Apple’s actions in this regard are fairly normal, and the company does not appear to have suffered any adverse effects arising from its foreign exchange rate risk as the result of this program.
General Economic Analysis
This section will outline the effects that the general economic conditions are expected to have on the risk that Apple faces. The economic environment will be outlined, the risks analyzed, and conclusions made with respect to Apple’s strategy to address these risks.
Apple is a differentiated provider, and prices its products at a premium. These superior margins grant Apple leeway with respect to pricing, but they also place the company at risk of changes in economic circumstances. According to the 2012 Form 10-K, Apple’s sales are geographically diversified. The Americas account for 36.7% of net sales, Europe 23.2%, Japan 6.75 and Asia-Pacific 21.2%, the remainder being retail. This geographic diversification helps to mitigate the economic risk that Apple faces. The largest markets in terms of exposure are the United States and the European Union. The economic situation in the United States is moderately favorable at present. The Congressional Budget Office’ latest figures show that expectations are for a decline in the U.S. economy in 2013, but these figures price in the effects of the Budget Control Act of 2011, in particular the sequester, and most analysts do not believe that these provisions will go into effect. The CBO projected an increase in the U.S. GDP of 2 1/4% for the second half of 2012, building on an increase of 1 ae % in the first half. The CBO’s alternative projections, wherein the sequester would not occur, show a continuation of economic growth roughly in line with recent rates.
The CBO projects that the lack of strong recovery will keep inflation and interest rate suppressed for the foreseeable future. It is projecting an inflation rate of 1.4% for the 2013 fiscal year, below the projected annual average and below the target range set by the Federal Reserve. The market agrees with this assessment. Short-term Treasury paper carries a yield of only 0.1% and ten-year notes are at 1.8% and expected to stay at those levels for the next year. Thus, there is no credible threat of inflation. Corporate profits are currently improving as American businesses gradually emerge from the recession. There has been some recovery in consumer spending, and even signs of life in the housing market (Conerly, 2012), all of which are encouraging signs for economic recovery.
The situation in Europe is more challenging. Both the Eurozone and the United Kingdom are either back into recession or headed in that direct, the result of absurd austerity policies and the effects of the Greek crisis. While the Greek crisis looks to have been averted, this will only turn attention of Euro-skeptics back towards Spain and other nations. Europe has also not yet admitted its austerity policies were a brain-dead failure based on faulty ideology, so it may continue to pursue those policies in the future, further constricting growth. Eurozone growth is expected to improve by 1%, at best, in 2013 (EC, 2012). Japan’s economy remains mired — while the country is wealthy it has little growth prospect. China remains growing quickly, but inflation is still a risk to growth there (Wang, Yao & Koh, 2012).
Apple enjoyed tremendous success over the past four years, despite the economic slowdowns worldwide. The company has enjoyed incredible growth in Asia Pacific and in Japan, but has also grown rapidly in the Americas and Europe. The company’s product innovations have driven this growth despite the economic slowdown. These slowdowns often affect consumers outside of Apple’s target market (uneducated, rural, older), so the company is less likely to be affected by such slowdowns compared with many other firms. In particular, new product innovations of the past five years like the iPhone (51.4% of sales) and iPad (20.7% of sales) have been key growth drivers. Some older products — iPods, desktops and software — have not seen significant sales growth (2012 Annual Report), indicating that product plays more of a role in the company’s success than the economy — without new products Apple might well be affected by shifts in the economy.
Apple’s success has been the result of tremendous growth in the industries in which it competes. The iPhone, for example, is Apple’s largest selling product, accounting for over 50% of all sales. Sales have surged, growing by 87% in FY2011 and 71% in FY2012. The iPad grew 311% in FY2011 and 59% in FY2012 (2012 Annual Report). The growth in these products, however, relates specifically to the growth of these industries as a whole. Despite the incredible growth figures of the Apple products, Apple has actually been losing market share in these mobile consumer products over the past couple of years. Apple had first mover advantage in tablets and the iPhone revolutionized the smartphone industry giving it de facto first mover advantage there. However, Apple’s global market share in smartphones is now down to 14.9% compared with Android’s 75% share (Perez, 2012) and in the U.S. Apple’s share is 48.1%, with the company only regaining the lead from Android with the release of iPhone 5 and no corresponding release of major Android product (Rodriguez, 2012). The threats within the industry add to Apple’s risk considerably. The fact that these industries are subject to constant innovation and a fast pace of change increases the business risk of any firm in the industry. While Apple is hugely profitable in the industry today, continued bleeding of market share could impact on the company’s pricing power in the marketplace in the future. Apple is particularly vulnerable in foreign markets, where it is less entrenched than it is in the U.S. market.
Apple, in general, seems to have questionable preparation for dramatic changes in the industry dynamic. The company’s strategy has always been to compete as a differentiated provider with premium products at premium prices. The company believes that this strategy will allow it to always have a profitable niche. The company’s recent successes have it well-positioned financially, but strategically Apple runs the risk of becoming obsolete if it cannot maintain technological leadership. That leadership is the only thing that will keep Apple “in the game” — they are performing well financially but underperforming in terms of market share and only have technological leadership to defend against that risk.
Apple designs and markets consumer electronics. It has a number of product lines including smartphones, tablets, music players, laptops, desktops and software. The company has premium positioning and relies on branding and innovation as forms of competitive advantage. Apple also has a superior marketing philosophy and infrastructure that has helped it to gain its market share. In recent years, it has been at the forefront of two major revolutions in consumer products. First, it entered the niche smartphone industry and brought mainstream consumers to a segment that previously had been dominated by business consumers. The company then brought back the tablet segment. The company’s fortunes in the past five years are almost entirely due to those two products, along with the genius-level marketing strategy the company has employed.
The result has been tremendous growth in the company in all facets (except market share). Apple’s stock currently trades at $584. Five years ago, the stock was at $194.30, so it has increased 201% in the past five years. The stock peaked at over $700 per share in September, 2012 before coming down to its current level. From this decline, the stock price has increased again, after the announcement of the iPhone 5 and the iPad Mini, reflecting the correlation between new product innovations and financial success at Apple. Earnings per share growth has been incredible. Five years ago, Apple earned $6.78 per share; in 2012 it earned $44.64 per share. The company paid out its first dividends in 2012, a payment of $2.65, or a yield of 1.81% (MSN Moneycentral, 2012). The company expects to pay a regular dividend from this point forward, but has yet to reveal how fast this dividend will grow, and there are no trends on which to draw.
The stock’s beta is 1.21, indicating higher than average level of volatility — it grows faster than the market. In other measures, cash flow from operating activities has increased fivefold since FY2008, moving from $9.5 billion to $50.8 billion. Sales have also increased rapidly, moving from $37.4 billion to $156.5 billion over that same time period. The number of shares outstanding has not changed much in the past five years. Apple no long-term debt — the company has $29 billion in cash and a further $92 billion in long-term investments, so debt is not required to finance the business.
The company’s innovations come from a centralized development and design team that creates new products, and has enjoyed considerable success of late. The company’s marketing is another internal competency that has allowed it to excel. The in-store and online shopping experiences are simple, the product choices are easy, and the company does everything to make it easy for consumers to buy Apple products. Even the choice of FedEx for shipping adds value to the company, since the online tracking FedEx offers gives consumers piece of mind that cannot be achieved with lesser logistics partners. By mastering product and marketing, Apple makes the most significant contribution to its own success, and has also contributed to the development of the industry as a whole by sparking the smartphone and tablet industries.
The outlook for consumer electronics in general is excellent. Western markets are not yet mature, but even when they do mature innovation will always drive new growth. Foreign markets are often in their infancy, with tremendous growth potential still on the table. Apple’s management thus far has been excellent, but the company will need to keep the innovation pipeline going in order to maintain leadership. Its marketing remains an industry standard, but its products will need to maintain that leadership as well. The company’s management is exceptionally capable, and it will need to be.
Assessment of International Economic Exposure
Apple needs to have measures for foreign currency exposure and for Chinese inflation exposure. Both of these can affect the company’s profits. The company’s management of international risk was discussed above, but to review it hedges F/X exposure, and relies primarily on innovation to deal with the risk posed by the industry’s rapid technological change. At present, it is not known how Apple manages the risk of inflation in China but its premium pricing does provide it with a margin buffer. The company manages its exposure through geographic diversification. Its level of geographic diversification has increased in the past few years, especially with growth in Japan and Asia-Pacific. Overall, the company’s exposure to foreign currency risk is about normal for a firm that sells its products in a variety of different markets. Apple employs normal hedging techniques to address this exposure. The company’s attitude to non-F/X risk is perhaps more worrisome. Apple believes strongly in its ability to maintain premium positioning in the market, but some analysts are skeptical of this, especially given the importance of Steve Jobs to the new product pipeline (Thompson, 2012). In the company’s one big test in the past year with adverse international operating exposure — the Foxconn situation — it appears to have handled that test well, but the issue is an ongoing concern (Adams, 2012). As the problem does not affect demand, and there are myriad other suppliers who would be more than willing to work with Apple, these problems are not seen as significant. Most analysts agree that Apple is well-positioned to continue enjoying strong profits, but are hesitant to make long-term predictions about the company. Anybody predicting the consumer electronics industry five years hence is playing a mug’s game — nobody predicted the tablet five years ago yet Apple sells $32 billion of them today. Such predictions are for fools, but most analysts believe that Apple’s management, brand loyalty, marketing expertise and financial resources will allow it to maintain a strong position in the coming years.
The most likely scenario is that the new few years will see iterations of the same products. Apple will continue to be a competitor and innovator in the field, but will evolve into a niche player. If it can continue to grow in foreign markets, and maintain most of its U.S. market share, then Apple’s performance over the next five years will be exceptional. The company is sitting on two major cash cows and barring major industry changes it will milk those cows for the foreseeable future. The company’s P/E is only 13.25, so the market tends to feel that there is not much growth from here for Apple.
The best case scenario would have Apple introduce the next major consumer product innovation, delivering for it first mover advantage, short-term market dominance and large profits in the long-term. This pattern would see Apple’s strength extended out five or ten years. This has worked for Apple twice in the past five years to bring the company to the position it is in today, which would have exceeded the best case scenario five years ago of anybody not named Steve Jobs. The worst case scenario has another company introduce the next major innovation in consumer electronics, especially if that product replaced either the smartphone or the tablet. Should that occur, Apple would see its products fall behind the innovation curve. This loss of competitive advantage would have the company in a worse position than today in terms of revenue, profit and market share, along with stock price. The pace of change in the industry is so great that there is tremendous variance in the scenarios. Again, thinking back five years, the consumer electronics industry looked very different than it does today. This industry changes quickly, and Apple’s ability to innovate and stay in front of those changes will have everything to do with its ability to continue making money the way it has lately.
Apple has achieved incredible results on the basis of a steady stream of innovation that has transformed the consumer electronics industry. Apple has lost market share in its core products but has seen incredible growth anyway — that is how fast these markets have grown. Apple has expanded internationally at a rapid pace in recent years, and that has brought with it increased risk. Apple uses geographic diversification to hedge against market risk, and foreign currency hedges to deal with F/X risk. The company believes that the only way to hedge operational risk is to continue to be the innovator in the industry. Not only does the company believe it has the ability to continue to do that, but many industry observers do as well. However, the P/E ratio suggest that the market is wary, most likely due to questions about the company’s leadership since Steve Jobs died, and the high level of risk in the industry posed by technological change.
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