Financial Alchemy: David Einhorn’s “value” play for Apple

If you are an Apple stockholder, yesterday was an eventful day. First, you had David Einhorn becoming more “activist” with his Apple holdings, moving from being just bullish on the stock to pushing for change. Second, Einhorn also unveiled his plan for Apple: the company should give its stockholders preferred shares in the company, with a 4% dividend yield. In pushing for the change, he is quoted as saying that doing so will “unlock billions of dollars in value".

There will be NO value created.. none.. 
Before I look at the trade off on and the alternatives to the preferred stock issue, let me dispense with the one part of his claim that cannot hold. Issuing preferred stock will not add value to the company, not one cent. Before I get accused of being a “theorist” or “academic” (which I now know are code words for much worse insults), let me explain my rationale:

1. The first law of thermodynamics, applied to value: You cannot create value out of nothing and giving preferred stock to your common stockholders is a “nothing” act, as far as the value of the company is concerned. It will not increase the cash flows from operations nor will it alter the risk in Apple’s business. 
2. The cost of capital will not change: This action will not change the cost of capital. At first sight, it looks like it should since the cost of preferred stock, at 4% (assuming that it trades at par) is much lower than Apple’s current cost of equity (which I estimated at 12% or higher). However, that savings is a mirage, since common stockholders will now have to price in the risk of the additional commitment that has to be met (the preferred dividend) into the cost of equity. If this were not true, every company with a healthy cash flow (Coca Cola, Microsoft, Google) could become a money machine, granting preferred stock to its common stockholders. 
3. The constant PE ratio is a myth: The most cringe worthy argument that I read yesterday was the one that went as follows: Apple currently trades at a PE of approximately 10.2, $450/share on earnings per share of $44. If you grant each common stockholder a $100 preferred stock, with a dividend of $4, your earnings per share will drop to about $40, and preserving the same multiple will generate a value per share of $400. Add that on to your preferred stock that is worth $100 and you have valuation magic: you have created $50 in value. This is the worst kind of nonsense, since it is nonsense with a believable twist to it, and that is why it has been investment conman’s favorite tool over history. The PE ratio is not a constant, and it will change as you change the nature of your equity risk or cash flows, as you are in this case. 

Bottom line: If Apple’s share were trading at fair value today (let’s say, at $450/share) and each Apple shareholder were granted a preferred share, with a preferred dividend of 4% and face value of $100, here is what the shareholders will end up holding tomorrow: a common stock with a value of $350 and a preferred share with a value of $100.

But the price MAY be affected
While I would contest Mr. Einhorn's claims of "value creation", let me take a more charitable view of what he is trying to do. Perhaps, he is trying to unlock the “price’, rather than the value, a distinction that may make more sense if you read my post on value versus price from yesterday. To make this "unlocking price" argument, you have to not only assume that the stock is under valued (which I would support) but that the under valuation is occurring for a very specific reason. It is not because investors are misjudging the value of Apple’s operations but because they are not giving Apple credit for either its huge cash balance ($130 billion +) or its capacity to generate huge cash flows ($30-$40 billion/year), for one of two causes:

1. There could a trust discount attached to the cash balance, because investors are worried that Apple might be tempted to do something stupid with the cash, and with this much cash, there is only one action that can do you significant damage and that is overpaying on a really large acquisition. 
2. Investors may fear that while the cash builds up in Apple, they may never see the cash, because managers are so attached to it that they will not let go or because it is trapped and therefore unavailable for user, due to tax reasons. 

If investors are discounting cash for one or both of these reasons, the preferred stock may serve to increase the price because it commits Apple to returning the cash (in the form of preferred dividends) in perpetuity. Presumably, “relieved” investors will now breathe a sigh of relief and remove the discount on cash, causing the stock price to go up. The upside is limited to the discount on the cash. Even if cash is being treated as worth nothing today (which would be a 100% discount), that would translate into $140/share.

Even if we accept this argument, though, it is not clear that granting preferred stock to common stockholders is the optimal way to create this commitment. In fact, there are three alternate routes that the company can go:

1.  Increase common dividends: The simplest and least involved alternative is to increase the common dividends per share from the existing level of $10.60 per share to a higher value. In fact, if you are looking at granting a $100 preferred stock with a 4% dividend to each common stockholder, you could create an almost equivalent commitment by just raising dividends per share by $4/share. I know that the commitment is a little weaker, since common dividends are not guaranteed, but given how sticky common dividends are (healthy companies very seldom cut common dividends), but not by much. In fact, since investors tend to build in expectations of growth into common dividends that will not get built into a perpetual preferred share, the net commitment effect may actually be neutral. 
2. Buy back stock or pay a special dividend: If investors distrust you with cash or are discounting it, the best response is to return in right now, rather than commit to return it to the future. The problem for Apple, though, is that a big chunk of the cash cannot be touched unless Apple decides to pay the “differential tax” (between the foreign tax rate and the US tax rate) on the trapped cash (estimated to be $80 billion+ of the cash balance). With Apple’s cash balance, though, you could still put together a substantial buyback ($40 billion) and commit to more buybacks in the future. 
3. Issue bonds: Instead of giving common stockholders shares of preferred stock, you could give them Apple bonds instead. The advantage of doing so is that you could now potentially have a value impact, not because your operations have magically become more valuable but because the government in its wisdom allows you to subtract interest expenses for tax purposes. Thus, if you were able to give each common stockholder an Apple bond with a face value of $100 and an interest rate of 3% (unlike the preferred stock, you cannot arbitrarily set interest rates at any level you want, since the tax authorities will object), the potential value of the tax benefit per share , using a marginal tax rate of 40% and a cost of capital of 12%, can be computed as follows:

• Interest tax savings each year = $3 (.40) = $1.20 
• Present value of these savings in perpetuity = $1.20/.12 = $10/share 
• The commitment to make interest payments is far stronger than the commitment to pay preferred dividends, since the consequence of failing to make interest payments is default. That is why there is a limit to how many bonds you can issue, before the trade off starts to work against you. 

Faced with these four choices: the Einhorn preferred stock grant, an increase in common dividends, a stock buyback/special dividend and bond issuance, there is one final consideration to keep in mind. The common stockholders in Apple have to think about the consequences of each of these for their personal taxes. With the common dividends and buybacks, we are on familiar ground and the effect on taxes is straightforward. Dividends will be taxed at the 20% dividend tax rate for most individual investors, as will the capital gains that arise from a buyback and are close to equivalent (though there is a tax timing option embedded that gives the latter a slight advantage). With the granting of preferred stock or bonds to existing stockholders, there is an added tax twist to consider. The preferred dividends will get taxed at 20% whereas interest income from bonds is taxed at the ordinary tax rate (higher than 20% for most investors), giving preferred dividends an advantage over bonds (but not over common dividends/buybacks). In addition, from my limited understanding of tax law, the grant of bonds will be treated as income at the time of the grant whereas the grant of preferred stock will not. (Thus, the Apple stockholder who receives a $100 Apple bond will be treated as having income of $100 in the year of the grant, whereas the receipt of $100 in preferred stock will just reallocate the basis for the Apple stockholding). 

Bottom line: If the objective behind the preferred stock is to remove the “trust” or the “trapped” discount on cash, why create a complicated mechanism, when a simple one will do? Just raise common dividends, if you do not want to open the door to debt at the moment, but leave that door ajar for the future.

Preferred Stock: The Big Picture
Contrary to many reports that I read yesterday, preferred stock is neither widely used nor is it favored by mature, non-financial service companies and for good reason. It brings many of the disadvantages of debt into a company (the fixed commitment, albeit with lesser consequences for failure to pay) without the tax benefit. In fact, there are three big users of preferred stock and Apple does not fit into any of the three categories:

1. Control freaks: The use of preferred stock is widespread in some parts of the world, such as Latin America, but it takes both a different form (from US preferred) and often has a different motive. In much of Latin America, preferred stock does not entitle you to a fixed absolute dividend but instead gives you a first claim on the dividends and a percentage of the profits. Thus, these preferred shares are really common stock without voting rights. They are used by companies, where insiders hold the voting shares and have no desire to be accountable to the capital markets. 
2. Young and start-up firms: Young firms often use preferred stock to raise capital because they want to raise capital, without diluting the existing owners’ stakes in the companies. For these companies, the tax benefits of debt are irrelevant in the decision process, since they are often money losers, and the risk of default is too high. To sweeten the pot for investors, they will often add the option to convert into equity to the preferred stock (creating convertible preferred shares). 
3. Financial service firms: Financial service firms use preferred stock because some measures of regulatory capital allow them to count preferred stock as part of capital. Thus, while they view preferred stock as expensive debt (since it does not have the tax advantages), it does serve the purpose of augmenting regulatory capital. 

Studies of both US and European companies suggest that when CFOs are asked about their preferences on raising funds, there is a financing hierarchy. Topping the list as most favored is straight” debt and at the very bottom of the list is preferred and convertible preferred. For non-financial service firms, the issuance of preferred is more a sign of desperation than it is of health. No matter what you think about Apple’s prospect, I don’t think you would view them as being desperate for new capital right now.

Generalizations
If David Einhorn’s idea is a non-starter when it comes to value creation and not particularly effective even as a price catalyst, he is not alone in his sales pitch. In fact, what he is doing is widespread among companies, consultants and banks and I would propose three changes in the way restructuring plans/ proposals are presented to investors and public.

1. Stop using price and value as interchangeable terms: Much of what passes for value creation in many companies is not what it is made out to be. I have seen the hue and cry around stock splits, issuing tracking stock and accounting restatements of assets on balance sheets and wondered why we make such a big deal about these actions. All of these tend to be purely cosmetic and have no effect on value. However, they could impact stock prices, if there is a gap between value and price. So, let’s require truth in advertising. 
2. When you talk about value enhancement or creation, be specific: If an investor, company or consultant claims that an action will enhance value, the onus has to be on the claimant to explain where the value increase is coming from. Simply put, it has to come from increasing cash flows in existing assets, reducing the risk in these cash flows, improving the tax benefit/default risk trade off or from growing more efficiently (improving competitive advantages). That is a broad canvas and every true value enhancing action has to wend its way through one of these paths. 
3. If you are talking about price enhancement, say so: If you believe that taking an action will increase your price (and has nothing to do with value), don’t claim otherwise. Here again, be specific about what market mistake or friction you are exploiting. If at the limit, your argument is that the price will go up because investors are naive or stupid (which is the basis for the constant PE argument), you might as well say so. 

In closing, I am glad, as an Apple stockholder, that David Einhorn is rocking the boat, even if I think his proposal is the not the most effective catalyst or game changer. It opens the door to a healthy discussion about how Apple should deal with its large and growing cash balance, and that is a good thing for all concerned.