David Einhorn's Apple Proposal Is Just Financial Engineering - You Can't Get Something From Nothing
Einhorn wants Apple to issue a new class of preferred stock that will pay a 4% dividend in perpetuity.
Einhorn argues that Apple's issuing this stock will immediately create hundreds of billions of dollars of new wealth for Apple shareholders, by "unlocking" the value of the cash on Apple's balance sheet.
Although anything is possible--the stock market sometimes behaves in strange ways--it is important to note that Einhorn's plan does not actually create any new value for Apple or Apple shareholders.
It's just financial engineering.
And assuming investors aren't currently being completely stupid in evaluating Apple's assets and business, this financial engineering should not deliver a huge boost in wealth for those who own Apple stock.
As BI editor Joe Weisenthal explains here, Einhorn's premise is that investors are not assigning the proper value to the $137 billion of cash on Apple's balance sheet.
Einhorn is certainly entitled to his opinion, and there's no way to prove what value the market is actually attributing to this cash versus the value the market is placing on Apple's business. All we know is that, together, the market values the cash and the business at about $430 billion.
As I explained in detail in this article, that value looks low relative to the combination of Apple's business and Apple's cash. But since the value of a stock is based in part on what happens in the future--and because no one knows what will happen in the future--no one knows for sure what Apple is worth.
This "no one," it must be said, includes David Einhorn. All we know is that, relative to current earnings, Apple's stock looks cheap.
(Importantly, if Apple's business and profit margins decline over the next few years, Apple's stock is not currently cheap. BlackBerry and Nokia looked cheap in the years before their businesses collapsed. So did Palm. None of those stocks were actually cheap. I don't think Apple's business will collapse, but I do think their profit margin will decline. The question is how much. The bottom line is that, no matter how confidently people tell you that they know what will happen with Apple over the next few years, they don't know. They also don't know whether the stock is cheap or whether the market is correctly valuing Apple's cash. All they know is that the stock looks cheap.)
So, anyway, David Einhorn wants Apple to give shares of a new class of preferred stock to current shareholders.
These preferred shares will pay a 4% dividend.
Einhorn suggests that Apple issue $50 billion of this preferred stock, which will mean paying out $2 billion a year in new dividends.
Einhorn suggests that this will "unlock" the value of all the cash on Apple's balance sheet and finally clue the market into the fact that it is not valuing that cash properly.
I think the market probably is valuing the cash on Apple's balance sheet properly.
I think that if Apple published a press release tomorrow morning saying that an employee had embezzled the entire $137 billion of cash and then vaporized, Apple's stock value would drop by about $137 billion. Apple is the single-most-scrutinized public company in the world, and I think the market is, in aggregate, very much aware of how much cash Apple has. And I think the market is probably assigning a perfectly reasonable value to it.
If Apple issued $50 billion of new preferred stock, this preferred stock would be "senior" to Apple's common stock--the stock that trades for about $450 a share these days. What that means is that, if Apple got liquidated tomorrow, the folks who owned the preferred stock would get $50 billion off the top before Apple's common shareholders got anything.
If the market is behaving even remotely rationally, the market should therefore respond by knocking the value of Apple's common stock down by about $50 billion.
In other words, if Apple issued $50 billion of this new class of preferred stock tonight, the price of Apple's common stock should open tomorrow at about $400 a share.
Why?
Because no matter how good a financial engineer you are, you can't just wave your magic wand and make something out of nothing.
If Apple issues this stock tonight, the value of Apple's enterprise and assets will not change. All that will change is the form of ownership of, and claim on, these assets. And the folks who own the $50 billion of preferred stock will have a more senior claim on those assets than the folks who own the common stock.
Einhorn may believe--and he may be right--that Apple's issuing preferred stock will befuddle mom and pop investors who won't take the time to understand that they now have a claim to less of Apple's assets than they did before.
And Einhorn may hope that, as a result of this befuddlement, the market will misprice the preferred stock and common stock, thus allowing him to do what every financial engineer wants to do--appear to create something out of nothing.
And, again, Einhorn may be right. He's brilliant. And anything is possible.
But Einhorn shouldn't be right. If the market is behaving rationally, Apple's overall value should not change. The issuance of new preferred stock should reduce the value of the outstanding common stock, such that the transaction is effectively neutral.
Furthermore, if the goal is to "unlock value," issuing preferred stock is needlessly complicated.
Instead of issuing new preferred stock, Apple should just significantly increase its regular dividend.
This will not require Apple to "repatriate" the cash that it holds overseas (to avoid taxes)--the logic that Einhorn uses to explain why Apple shouldn't just do a huge share buyback.
Apple's U.S. business generates enough cash that Apple can pay these future dividends out of its U.S. operations.
This will have pretty much the same effect as issuing preferred stock that pays a dividend--except without needlessly complicating Apple's capital structure.
Again, David Einhorn is brilliant. And, unlike mom and pop Apple shareholders, David Einhorn will certainly be able to exploit any inefficiencies in how the market is valuing two classes of Apple stock. And David Einhorn may believe--and, importantly, may be right--that he can persuade the market that Apple should be worth more if it issues this preferred stock.
But, over the long haul, the market generally gets it right.
And "right" in this case is the observation that you can't create something from nothing. (At least not with financial engineering.)
SEE ALSO: Apple's Stock Looks Cheap