EINHORN ON APPLE: You're Wrong, Henry - I CAN Create Something Out Of Nothing!
In that article, I described Einhorn's Apple proposal as "just financial engineering" and argued that even he couldn't create something out of nothing.
By issuing preferred stock, I argued, Apple would just depress the value of its common stock- — so that the transaction would not, in aggregate, create much new value for shareholders.
As you can see in the email exchange below, Einhorn disagrees with that conclusion.
Of all the ways that Apple could return some of its massive cash mountain to shareholders, Einhorn believes that his "preferred" idea would be the most effective and efficient. And he offers an example in which 1+1 would, in fact, likely produce a value that is at least modestly greater than 2.
I still think the preferred idea is needlessly complex and that Apple should instead return cash to shareholders by increasing its dividend and share buybacks.
But Einhorn's idea is certainly creative.
And there are three things that we very much agree on:
- Apple looks undervalued.
- Apple has way too much cash.
- Apple could create more value for shareholders by returning some of that cash.
Here's the email exchange (lightly edited):
DAVID EINHORN:
Hi Henry,
A few points:
1. I don't believe that markets are efficient. We can agree or disagree about that. I think Apple is mispriced. We can argue it another day.
2. Capital allocation matters. Cash and future cash that will be invested at 1% is worth less than cash and future cash put to a higher and better use. Value can be unlocked by signaling a higher and better use.
3. As a thought exercise: If Apple distributed $430 billion of 4% preferred. It would cost $17.2 billion in annual dividends. If you took the $430 billion of value out of the common, under your math, the remaining common would be worth zero. Obviously, that can’t be right. What if they issued $500 billion?
de
ME:
David,
You are vastly more sophisticated about this than I am, but here are some quick thoughts.
I agree that Apple looks undervalued. (I wrote about that here). But I also do think it's possible that they are now entering years of margin and pricing declines and loss of competitive edge that would make today stock's multiple look less cheap than it currently appears.
If Apple issued $430 billion of 4% preferred tonight, the common stock would effectively become an at-the-money option with no expiration date. As you suggest, that would indeed be worth something. But I still think the value of the common would get absolutely creamed. And I think the common would get even more creamed if they issued $500 billion of preferred. So you might get 1+1 to equal modestly more than 2 (at least temporarily), but I would be shocked if you got the hundreds of billions of additional aggregate value that you're referring to.
(If this tactic were in fact to produce a sustainable increase in aggregate value, then pretty much every company in the economy should do it.)
My question, which I don't think was asked on CNBC, was why not just radically increase the common dividend and use cash flow from US ops to pay it? Wouldn't that get you to a similar place without complicating the capital structure or paying the repatriation tax
DAVID EINHORN:
It is a question of math.
After a $430 billion distribution of preferred…
Apple would have $145 billion of cash (that will remain unencumbered), its franchise, and future earnings.
If Apple is earning about $40 billion a year now, it would be earning about $23 billion after paying out $17 billion in preferred dividends.
All of that residual would belong to the common.
It would not be an “at the money option”…it would be an “in the money option”…
The market might judge the p/e to still be 10x and value it at $230 billion. Or it might value it at 7x and add back the cash ($300 billion). Or it might say, “We like Apple’s new shareholder friendly use of future profits” and raise the multiple.
Or it might do something else.
But whatever it is the sum will be much more than the parts
ME:
I am conceding this whole argument to you in advance because you're way smarter than I am.
Having said that...
1) Why would the $145 billion of cash be "unencumbered"? If Apple were liquidated, the preferred would get paid out first. That cash would instantly be handed over to the preferred shareholders, and there would still be ~$290 billion of preferred left to be redeemed. And that's before the common stockholders got a penny.
2) I think one of the reasons Apple is trading at a 10X p/e is that the market thinks the earnings are going to decline over the next several years. By committing to paying out $17 billion of dividends per year in perpetuity, Apple would be severely reducing the percentage of earnings owned by the common shareholders. Therefore, if Apple's earnings shrank, the common shareholders would take the entire hit. If, god forbid, Apple's business went into a secular decline, common shareholders would get squeezed more and more each year.
3) Other than possibly engineering a one-time pop in value, why not just radically increase the common dividend? Or buy back stock? If you're going to pay out $17 billion of preferred dividends each year, you're going to be paying that repatriation tax (even if you do it out of current earnings--because Apple doesn't make $17 billion in the U.S. each year). So if you're deciding to pay that tax anyway, why even bother with the preferred? Why not just increase the common dividend to $17 billion.
4) Do you think that creating a preferred/common capital structure would increase every profitable company's value? If yes, why shouldn't all companies do this tomorrow? (Maybe they should--I'm just curious about your position on this).
5) If the point is to lever up the equity, why not just borrow money? Should Apple just borrow $100-$200 billion (at unbelievably low cost) and use the proceeds to pay out a massive one-time dividend? There would be no repatriation tax on this, and then Apple would get to deduct the interest costs. In other words, what is the advantage to preferred?
DAVID EINHORN:
To your points:
1. Technically you are right, but only to the extent Apple was liquidated. The cash is “unencumbered’ in that the preferred will not have a security interest in the cash. If subsequent to the issuance of the preferred Apple decided to do something with the cash, it would be free to do so. It could buy something, invest in its business or even pay a big dividend to the common.
2. That is one of the reasons. But, it isn’t the only reason. The poor capital allocation is another. But, to your point, the common would become more exposed to changes in earnings. If earnings were to resume growing (even if off a lower base, in your scenario) the EPS growth rate of the common would be higher than it otherwise would be under the current structure.
3. I have nothing against dividends or buybacks. From where I sit, Apple has more cash than it needs. I am aiming for a clever solution where Apple gets to keep its war-chest (which is says it needs) and shareholders can get the value unlocked. A big buyback or one-time dividend doesn’t do those things. I also think that the market will reward the preferred dividends at a higher valuation than it will the common dividends because preferred shareholders will only need to focus on the non-volatile income stream. Common shareholders have to pay attention to many other things in addition to the dividend, so the value of common dividends is not rewarded by them in the same way. As for $17 billion – that was hypothetical so I could show you the problem with your math. Our suggestion is to start with $50 billion of preferred and a $2 billion dividend and take it from there. Repatriation is a factor that should be taken into account in judging the ultimate size.
4. This is an idea that should have appeal to a lot of companies – but particularly those that insist on have debt free (or nearly debt free balance sheets) and large war chests of cash. We proposed this to Dell last year. They weren’t focused on shareholder value for reasons that are now apparent. Amazing how untouchable foreign cash can suddenly come into use.
5. Borrowing is an option. But, it is higher risk. Loans have covenants and refinancing risk. Preferred stock does not. Failing to repay a loan lands you before a bankruptcy judge. Failing to pay a preferred dividend does not.