Nothing like a snow day on Friday, blanketing much of the Northeast, including Toronto, to give me time to consider the proposal David Einhorn has given to Apple Inc.
Reading from Apple Inc.’s SEC filing, which includes Mr. Einhorn’s letter to Apple’s shareholders, Mr. Einhorn’s originally proposed a strategy where by Apple would issue perpetual preferred shares, at no cost, to existing shareholders back at a May 2012 investment conference. According to Mr. Einhorn he demonstrated that Apple could unlock several hundred billion dollars (my emphasis) of shareholder value.
Apple’s filing also noted since May, Mr. Einhorn has had discussions with Apple on his value creation idea, but Apple rejected it outright in September 2012 – rightly in my opinion. (Which I will get to.)
Apple not only rejected this idea, but has taken an additional step – some say unprecedented – to eliminate preferred stock from the company’s charter. To do this they need shareholder approval.
Fine. Are you with me so far?
Apple went a step further by “bundling” this proposal, the elimination of preferred stock, with two other proposals (majority voting for directors, and establishing a par value for the Company’s common stock) into one proposal. So shareholders can and will vote on the “bundled” proposal. Three proposals bundled together for one vote. Mr. Einhorn is suing Apple to have these three proposals, “unbundled”, so shareholders can have a say on each separate proposal.
Mr. Einhorn’s Proposal
Mr. Einhorn proposes that Apple distribute perpetual preferred stock to all existing shareholders at no cost. This perpetual preferred would trade in the marketplace and take advantage of the market’s appetite for yield obviously implying a premium valuation of this newly issued stock versus the common shares which many people including Mr. Einhorn believe trades at a discount.
To further quote from Mr. Einhorn’s letter (Bold lettering is my emphasis)
For example, Apple could initially distribute to existing shareholders $50 billion of perpetual preferred stock, with a 4% annual cash dividend paid quarterly at preferential tax rates. Once a trading market is established and the market recognizes the attractiveness of a highly liquid, steady yielding instrument from an issuer backed by Apple’s unmatched balance sheet and valuable franchise, the Board could evaluate unlocking additional value by distributing additional perpetual preferred stock to existing shareholders. With this conservative action, Greenlight [Mr. Einhorn’s Investment Company] believes the Board could unlock hundreds of billions of dollars of latent shareholder value.
Assuming Apple retains its price to earnings multiple of 10x and the preferred stock yields 4%, our calculations show that every $50 billion of perpetual preferred stock that Apple distributes would unlock about $30 billion, or $32 per share in value. Greenlight believes that Apple has the capacity to ultimately distribute several hundred billion dollars of preferred, which would unlock hundreds of dollars of value per share. Further, Greenlight believes additional value may be realized when Apple’s price to earnings multiple expands, as the market appreciates a more shareholder friendly capital allocation policy.
Not so fast.
Mr. Einhorn, through his proposal, wants to change the capital structure of Apple. (Instead of the operating nature of the balance sheet itself – which I will get to in a future blog.) By the issuance of perpetual preferred shares, these shares will have a claim on the earnings of the company ahead of the common shareholders. In other words, Apple would be separating the equity of the company in two parts – preferred and common shares. This additional claim comes at the expense of the common shareholders alone and no other group of stakeholders.
It would interesting to speculate what additional claims Apple may have to give these preferred shareholders. Keep in mind Mr. Einhorn wants these preferred shares to not only trade at par value but also at some sort of premium. (So additional preferred shares can be issued) Will this value be recognized with only an earnings claim against the common equity or additional claims have to be attached (claim on assets) to ensure after market trading gives market precipitants the valuation they are hoping for.
Two Thought Experiments
What if Apple has no earnings? Apple almost went bankrupt once without Steve Jobs and in this fast paced technology world this scenario cannot be ruled out. The question is how these preferred shares trade with its common cousins. We dare say the preferred shares would have all the value with no to little value subscribed to the common shares as the market correctly focused on the claims of each security.
What if Mr. Einhorn had his way and is able to issue hundreds of billions of dollars of these perpetual preferred shares? Again as a thought experiment, what if Apple issued $1 trillion of these shares. To expect NO diminution in the common stock value is unrealistic in my view.
How would Model Price account for the suggested Perpetual Preferred shares?
One of the key characteristics of Mr. Einhorn’s proposal is the perpetual preferred shares are issued at no cost. We would account for these preferred shares as equity but separate from the common equity of the company. This would lower the book value of Apple, thereby reducing our EBV lines, (see Key Concepts), as our EBV lines are a function of book value. Reduction in the EBV lines would have an impact on our model price calculation, assuming all variables in our model price algorithm are constant.
So for fun, we calculated a new model price assuming the issuance of perpetual preferred shares of say $50 billion with our current model price calculation assuming the status quo. The delta is roughly the same (model price delta times shares outstanding) as the value subscribed to these preferred shares or $50 billion.
So paradoxically the more perpetual preferred shares Apple issues, the more our model price calculation would diminish. How the market actually reacts to this reduction of model price is another question and maybe over the short term the market wouldn’t care of the siphoning of value from one security to the other. However over the longer term this assumption cannot be made.
Mr. Einhorn’s Proposal is “Wacky”, in my opinion!
In my opinion, proposing a major change in the capital structure of Apple to “unlock” Apple’s inherent value is the wrong way to go. Our math shows that for every perpetual preferred share issued our model price or fair market value calculation would be reduced by roughly the same amount. We concede the market maybe fooled in the short term however over the longer term we believe the market value of the common shares would recognize the diminution in claims and inferior capital structure position.
Mr. Einhorn’s proposal also has other qualitative negative aspects, which should be considered. The word “perpetual” is a long time! As long as the company itself is around. I’m sure this would be a legal and governance nightmare for Apple and its current and future shareholders. Not that would be a problem for Mr. Einhorn. I am sure once he “unlocks” any perceived value which his proposal claims to unlock, he will fly (sell) like the wind looking for other “special situations” to “unlock value” as he sees fit.
Apple Response is “Wacky” too!
As Mr. Einhorn points out in his letter over 90% of the S&P 500 companies have the flexibility to issue perpetual preferred shares in their corporate charters. For Apple to take this unprecedented action, the elimination of perpetual preferred shares from their charter is “wacky” in my point of view. To further “bundle” three (3) proposals together for one vote is beyond paranoid.
So in a nutshell, what is to make of all these shenanigans? All stakeholders, except for management and the Board of Directors, believe Apple has too much cash on its balance sheet – at $137 billion or $145 per share of cash – including us. Mr. Einhorn wants to force Apple into some sort of strategy to distribute some of this cash to shareholders, including him, obviously. Apple is playing hardball and overreacting to the situation – again in our opinion, but in doing so is breathing life and press coverage into Mr. Einhorn’s very bad idea.
The only people benefiting from these “Wacky” maneuvers, as usual, are the lawyers.
P.S. I have written two blogs last year on Apple and how in increase its market value by changing the operations portion of its balance sheet. (Instead of the capital structure that Mr. Einhorn is proposing.)
Apple – Four Actions Management Can Do To Double Their Stock Price (Without Breaking a Sweat)!
Apple Computer – A Special Dividend of $75 Billion would Reward Shareholders, management and the Economy.
P.P.S. I will update these blogs into a new blog dealing with Apple’s valuation at a future date. Unlike Mr. Einhorn’s proposal, Apple can change their balance sheet and improve, mathematically, their model price or fair market value from corporate actions other than changing Apple’s capital structure, which should be the objective of both Mr. Einhorn and Apple’s management.