Would David Einhorn’s Apple Preferred Stock Idea Really Create Shareholder Value?

This week hedge fund manager David Einhorn, whose investment management firm owns more than 1 million shares of Apple (AAPL) stock, publicly urged the company to take more meaningful action on its ever-rising cash hoard of $137 billion. Since management is not really taking the matter very seriously, despite the fact that every dime of that $137 billion belongs to the shareholders, Einhorn has proposed an alternative idea to unlock shareholder value; issuing preferred stock to existing shareholders, at no charge, with a 4% perpetual dividend.

His thinking revolves around the idea that Apple shares are not adequately valuing the cash on the company’s balance sheet, and issuing preferred stock would actually boost shareholder value because the new stock would have a quoted value in the market that  investors could actually monetize if they chose to do so. Einhorn is saying that if implemented, Apple shares post-preferred issuance would be worth more than they are today (because he does not think Apple common stock would fall by $100, the value of the preferred given out). In addition, the 4% dividend on the preferred stock would increase the company’s dividend obligation by less than $4 billion per year, which would easily be covered by future free cash flow and not eat into the current $137 billion cash balance.

So does this plan have merit? I think it does, but I would agree with many who say that it is an overly complicated solution to a relatively simple problem. That said, if Apple is unwilling to take more traditional steps for the benefits of shareholders (after all, Tim Cook and his team work for us), then an idea like this is worth considering (to be fair, since a large portion of Apple’s cash is overseas, repatriation tax issues complicate their possible strategies quite a bit).

Interestingly, today I read a post by Aswath Damodaran, a well known finance professor at NYU, who argues that Einhorn’s idea would generate no shareholder value whatsoever.  How he can make such a bold claim, to me, is quite odd. It is true that the idea right now is all theoretical, and there is not a way to know for sure how much the market would value Apple’s common and preferred shares if such an issuance was implemented, but Damodaran equivocally states that value can not be created out of thin air. Here is his exact quote:

“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.”

This concept is along the lines of something you are likely to find in a finance textbook. Damodaran would likely argue that a company is worth X, based on the discounted value of future expected cash flows, plan and simple, and slicing and dicing paper does nothing to change that.

I would respectively disagree for a fairly simple reason. I believe that something is worth what someone else is willing to pay. You have probably heard people say that a lot in a wide variety of contexts. For instance, if you are selling your house, just because it is appraised for “X” does not mean that is what it is “worth.” It is only worth the amount that a buyer is willing to pay you for it. Which is why real estate agents value their clients’ homes using “comps,” which are actual sale prices for comparable homes. Original asking prices, or appraised values, are not considered because they are not “real” prices.

The same is true of stocks. At any given time a share of stock is worth the market price, plain and simple. If Apple stock is trading at $470, as it is today, that is what you can sell it for. As a shareholder, that price represents its value to you. At that moment  you can either choose to own one share of Apple or $470 in cash. No other option exists.

Now, an analyst, or portfolio manager, or finance professor can do some number-crunching and conclude that they believe Apple should be worth more than $470 per share (in fact, both Professor Damodaran and I agree that Apple is a bargain currently), but just because someone believes that to be the case does not make it true. In order for our opinions to be proved right, the market has to price the stock at that level. That is the only way we could ever actually sell our stock for a higher price.

Investing in a stock is making a bet that its market value will be higher in the future, affording us the opportunity to sell our shares and make a profit. Professor Damodaran makes the philosophical argument that price and value are not the same, but I respectfully disagree. A share of stock is only worth what someone else is willing to pay and the price someone is willing to pay is the current market price.

So, back to the case of Apple. If the company took David Einhorn’s advice and gave investors $100 of preferred stock for free, for every share of Apple they owned, it is entirely possible that Apple common stock would trade above $370 (the current price less $100). We cannot prove that unless it actually happened, but it is a reasonable conclusion to draw based on Apple’s earnings power ($40 per common share in trailing EPS post-preferred issuance).

In fact, if Apple common shares fetched a 10 P/E, as Einhorn projects, the stock would be $400 and shareholders would then own $500 worth of Apple securities ($400 common plus $100 preferred). Considering that they can now only get $470 for their shares, there would indeed be $30 per share of “value creation” for shareholders. Again, Apple stock is only worth what someone is willing to pay. That amount is the current price. no more and no less. For anyone to argue that no value would have been created for investors in that scenario seems illogical. Price and value are one and the same because there is no guarantee that anyone will ever be willing to pay you what you perceive the value of something to be (how frequently that occurs will determine how good of an investor you are).

I remember reading about a line delivered by Donald Trump in 2007 when asked about his net worth. Here is the exchange:

Trump: My net worth fluctuates, and it goes up and down with the markets and with attitudes and with feelings, even my own feelings, but I try.

Ceresney: Let me just understand that a little. You said your net worth goes up and down based upon your own feelings?

Trump: Yes, even my own feelings, as to where the world is, where the world is going, and that can change rapidly from day to day …

Ceresney: When you publicly state a net worth number, what do you base that number on?

Trump: I would say it’s my general attitude at the time that the question may be asked. And as I say, it varies.

In this case Trump is using the same definition of value that Professor Damodaran seems to be using. Trump says his net worth is X. That is the perceived value, which is why he thinks it can be different based on how he “feels.” Of course, we know that net worth is a technical term. There is no perception involved. His net worth is the amount of money that would be left over if he were to sell all of his assets and repays all his debts. Plain and simple.

As for Apple, I am hopeful that Einhorn’s public challenge of Apple’s capital allocation policies kick-starts some changes at the company. There is no doubt in my mind, and many are in agreement, that the current market price of Apple is largely discounting the value of its massive $137 billion cash hoard. There is no other explanation as to why the stock current trades at a trailing P/E of only 7, especially when you compare it with other technology stocks.

Full Disclosure: Long shares of Apple at the time of writing, but positions may change at any time

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3 Thoughts on “Would David Einhorn’s Apple Preferred Stock Idea Really Create Shareholder Value?

  1. Chad,

    I wanted to send this comment in an email as it is rather long, but I found only Peridot Capital’s contact form, so I am posting here.

    I like your blog. I haven’t commented here so far, but after reading this post, I thought I’d like to add a tiny nuance.

    I can see where you are coming from with the argument that something is worth what someone else is willing to pay for it. I also understand the difference between price and value. Denying it is denying value investing.

    It is a matter of time horizon. Graham put it best when he described the market as a voting machine in the short term and a weighting machine in the long term. At any given moment, worth is determined by what someone else is willing to pay – supply and demand garnished with all the emotions of the moment. Over time, however, emotions even out. The cycle of supply and demand dynamics becomes apparent. Only then real worth – that elusive concept of intrinsic value – becomes obvious.

    This applies to Apple’s case. Damodaran is right in saying that issuing the preferred will be like a stock split – a non-event. It really doesn’t change the long-term cash generating characteristics of the business. However, psychological bias being what it is, it is pretty common to see a positive short-term reaction to a stock split. Such a reaction is entirely possible for the discussed preferred shares.

    I also find Apple’s low multiple perplexing. But I don’t think it’s due to the cash pile. Way more complicated companies with bizarre balance sheets are being valued (mostly) correctly by the market daily. It doesn’t make sense that the largest, most followed, most loved public company is being misjudged on such an obvious thing as cash by virtually everyone. Besides, Einhorn sees the multiple improving from 7 to 9-10 after the value-unlocking event. How is 9-10 much more adequate than 7 for a company like Apple?

    My view is that last year Apple was priced to perfection. It missed earnings and the illusion of perfection was ruined. The pendulum swung the other way. The other pertinent point is, and it has been written-up well by The Brooklyn Investor, that some investors are seeing Apple as the vulnerable tech company that it is, whose big idea guy is gone. It is anyone’s guess whether there will be any more new, widely-loved Apple products once Steve Job’s designs run off. Cook is not a products guy.

    That’s just my two cents.

    Student

    • Nuance is a good word, as I agree with much of what you have said. Still, I would push back on a few things.

      First, it is very true that in the short term market prices can be wildly influenced by factors that seem silly to long-term value investors (myself being one)… emotion and sentiment, near term supply and demand, technical chart patterns, one quarter’s financial performance, etc. Over the long term, the underlying true profitability of the company will overcome these short term factors, which is what value investors are betting on. Still, just because someone believes that a company is worth X based on future cash flow expectations, that does not mean that the stock is automatically worth X. The market still has to come around to share that opinion at some point. Simply a belief of what intrinsic value is does not make that number a true “value” because there are no assurances that the market will ever agree with you, in which case you will never be “right” and you will not have the chance to sell at your perceived “fair value.”

      Second, I believe it is very simplistic to conclude that since the preferred stock idea would not impact free cash flow, that any positive short-term impact on the stock would be temporary. Actions that impact stock multiples are by no means fake and create value for shareholders all of the time. We see that with spinoffs and such. The recent trend is to convert real estate developers into REITS because investors pay more for REITS than non-REITS in the property management business (PENN is a good recent example). The cash flow does not change, but the market will value the company differently and shareholder value is created. This is not simply a cosmetic, temporary change. Finance theory often sounds good in textbooks, but in reality there are many instances where the theories don’t play out in the actual marketplace. Einhorn is betting that AAPL would be a similar case, and I think he is more likely right than not, but we won’t know for sure unless they make a bold move.

      Lastly, as for Apple being priced for perfection at $700, that is a tough case to make in my view. AAPL’s enterprise value was about $550B at the peak, which was a 13X P/E and 12x free cash flow (both discounts to the market). That is hardly a stretched valuation, which would be required for being priced for perfection. Amazon, maybe, not Apple. I think today’s quote is more of an undervaluation than $700 was an overvaluation.

      Thanks for the comments.

  2. It is a valid point that intrinsic value is not created by wishing it was there. Also, since there is no way to be certain about it, we can only be approximately right or precisely wrong. The market could be wrong about Apple. I have no position, so I haven’t taken sides.

    At the moment, a lot of people are disagreeing what measure would best unlock Apple’s value. I side with the opinion that Einhorn’s plan is a complicated way to accomplish the easy task of getting rid of the cash pile. Certainly, this opinion could be wrong and the preferred could work as he describes it would.

    However, the issues I see with Apple have nothing to do with the cash problem. For me, the serious risks lie elsewhere. I pointed to the continued innovation issue in my previous comment. There is also the concentration issue since most income comes from the iphone. Then, I wonder, is there a market big enough to accommodate such a huge and growing company?

    I just came across this quote from Bill Gates, arguing that tech companies deserve lower multiples because they are risky. And while I agree that Amazon has a crazy multiple, I believe it is incomparably harder to bury Amazon than Apple. Probably I am not showing you anything new, but this is a great post contrasting the two companies. Needless to say, Apple and Amazon will make a great case study years from now.

    Meanwhile, we can sit and watch what happens with all that cash, which is over 2 times the GDP of my home country.

    It’s a pleasure exchanging thoughts with you.

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