Apple (AAPL) is moving up 2% in the pre-market session today. The reason it's moving up is rather novel. It all has to do with a letter David Einhorn wrote to the Apple shareholders.
In this letter, reproduced at the end of this article, Einhorn explains his opposition to a proposal that's being voted in Apple's Annual Shareholder Meeting, where Apple is seeking to eliminate from its charter the possibility of issuing preferred shares. More importantly, Einhorn also puts forward a proposal which he believes could unlock "hundreds of billions" in shareholder value. That's probably what's moving the stock, and that's what I am going to cover in this article.
What Einhorn is proposing, is basically that Apple could issue preferred stock and, instead of selling it in the market, it should give it to the existing shareholders. This preferred stock would be perpetual (thus never mature, never have to be paid back or refinanced). The preferred stock would carry an original yield of 4% as per Einhorn's example.
Einhorn is counting that Apple would regain and keep its existing valuation in spite of paying this "preferred stock dividend".
The main problem
For Apple to issue these preferred shares for free, there would have to be an ex-"preferred share" day. A day after which the shareholders would no longer have the right to receive the preferred shares. This would be analogous to Apple paying a special dividend, with the difference that creating these shares does not eat into Apple's cash pile - only paying the perpetual dividend reduces that cash pile. Since there would be an ex-"preferred share" dividend day, at that day Apple stock would probably fall by the market value of the preferred shares being offered. So at that point the move would be neutral.
Einhorn seems to be counting on the market being euphoric by the mere prospect of receiving something for free, much the same way some stocks like Costco jumped on the news of a special dividend. He is right about this - one just needs to see Apple's reaction today to know it. But still, it's somewhat troubling that this is sold as "value creation" when no value is created. Apple's enterprise value would remain the same, since these shares would have to be added to Apple's market capitalization.
It is also true that Apple being seemingly more shareholder-friendly could, subjectively, lead to an higher market multiple. The mere prospect of Einhorn turning more active is already propelling Apple upwards. One also wonders about the large rally which took place yesterday in Apple shares - could that have been a function of someone knowing about this letter beforehand?
From a corporate finance/valuation viewpoint, EInhorn's proposal would be neutral. However, from a Street-savvy viewpoint we know that at the very least this proposal can drive the stock upwards like it's already doing. It's likely that if Apple backs down and supports Einhorn's proposal, the stock would be pushed up as a result. Indeed, it would even launch a trend where other companies with cash piles decide to do the same to goose up their share prices.
This kind of move is more attractive than paying special dividends, because it gets almost the full effect of a special dividend while spending just a fraction of the cash hoard. One can't even say it increases the company's risk, because 4% takes 16-25 years just to draw down the same cash as an equivalent special dividend. In Einhorn's $50 billion example, Apple would be paying just $2 billion per year in dividends to get the same effect as a $32 billion special dividend.
All in all, it's rather weird to see Einhorn suggesting this kind of neutral move just because he rightly knows it will drive the stock higher. It speaks of some kind of desperation with Apple's move.
(the text of Einhorn's letter follows)
February 7, 2013
VOTE AGAINST PROPOSAL 2 AT THE FEBRUARY 27 ANNUAL MEETING TO PROTECT YOUR INVESTMENT IN APPLE
Oppose Apple's Effort To Restrict The Company's Ability To Unlock Substantial Shareholder Value
Dear Fellow Apple Shareholder,
Greenlight Capital, Inc. (and affiliates, "Greenlight") has been a significant shareholder of Apple Inc. ("Apple" or the "Company") since 2010. We believe Apple is a phenomenal company filled with talented people creating iconic products that consumers around the world love. We are long-term shareholders of Apple.
However, like many other shareholders, Greenlight is dissatisfied with Apple's capital allocation strategy. The combination of Apple's low (and shrinking) price to earnings multiple and $137 billion (and growing) hoard of cash on the balance sheet supports Greenlight's contention that Apple has an obligation to examine all options to create and unlock additional value.
We understand that many of our fellow shareholders share our frustration with Apple's capital allocation policies. Apple has $145 per share of cash on its balance sheet. As a shareholder, this is your money. Though Apple recently commenced paying a common dividend and initiated a nominal share repurchase program, we believe that there is much more that the Board should do for shareholders. We believe that it is important for shareholders to send Apple's Board the message that the current capital allocation policy is not satisfactory, and that after considering all options, Apple's Board should act to unlock the latent value of Apple's balance sheet and franchise. If you share our frustration, please join us in blocking the Company's effort to restrict its value creation options by voting AGAINST Apple's plan to amend its corporate charter in Proposal 2 to eliminate preferred stock.
Send Apple And Its Board A Message That We Want Apple To Change Its Capital Allocation Policy To Unlock Value For Shareholders - VOTE AGAINST PROPOSAL 2
At a May 2012 investment conference, Greenlight introduced the idea that Apple could unlock several hundred billion dollars of shareholder value by distributing to existing shareholders a perpetual preferred stock.
Since then, Greenlight has had discussions with Apple encouraging the Company to distribute perpetual preferred stock as an innovative method of rewarding all shareholders for the Company's strong balance sheet and substantial cash flows. Put plainly, Greenlight is encouraging Apple to distribute a perpetual, high-yielding preferred stock directly to shareholders at no cost. This would enable shareholders to own and separately trade the new preferred shares and Apple's existing common shares. Importantly, Greenlight believes these preferred shares represent a simple, low-risk way to reward shareholders without compromising the financial and strategic flexibility of the Company, or forcing the company to incur tax on repatriating its offshore cash balances.
Greenlight suggested an initial preferred share distribution, whereby dividends could be funded on an ongoing basis by a relatively small percentage of the Company's operating cash flow. Apple rejected the idea outright in September 2012. Yesterday, after Greenlight notified Apple of its intention to vote against Proposal 2, Apple said it would reconsider the idea, but refused to withdraw the proxy provision where Apple seeks to eliminate preferred stock from its charter.
The recent, severe under-performance of Apple's shares, which are down approximately 35% from their peak valuation, underscores the need for the Company to apply the same level of creativity used to develop revolutionary technology for its consumers to unlock the value of its strong balance sheet for its shareholders.
We believe our suggestion of distributing perpetual preferred stock, while innovative, is also quite simple. Apple could distribute high-yielding, tax efficient preferred stock to existing shareholders at no cost. This new type of easily tradable preferred security would allow Apple to take advantage of the market's appetite for yield while preserving future operating and strategic flexibility. Importantly, we believe this strategy would require no immediate use of cash other than the ongoing dividend, and would not pose any maturity, re-financing, balance sheet, or default risk.
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 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.
Apple's Attempt To Remove A Potential Means Of Value Creation Should Concern ALL Shareholders
As holders of more than 1.3 million Apple shares, Greenlight is alarmed that Apple is attempting to eliminate preferred stock from its corporate charter, hindering its ability to unlock value for shareholders. This is an unprecedented action to curtail the Company's options. We are not aware of any other company that has ever voluntarily taken this step. Furthermore, over 90% of the S&P 500 companies have the flexibility to issue similar preferred shares.
Apple is attempting to package this provision with two positive corporate governance reforms that we would normally support. Apple is asking shareholders to approve or disapprove of all three changes in a single bundled vote.
We believe that the Securities and Exchange Commission ("SEC") proxy rules require that Apple provide for a separate vote on each matter presented to its shareholders for approval at the shareholder meeting. This 'unbundling' rule is designed to permit shareholders to express their vote on each individual matter and to not be forced to vote on a combined package of items. This prevents companies from forcing shareholders to approve matters that they might not vote for if presented independently.
In our view, Apple's Proposal No. 2 violates the SEC's 'unbundling' rule because it ties together three separate matters (majority voting for directors, elimination of preferred stock, and establishing a par value for the Company's common stock) into one proposal. Apple should be required to unbundle these items into separate proposals to allow the shareholders to make an independent choice on each matter. Accordingly, Greenlight has initiated a legal action in the U.S. Federal District Court for the Southern District of New York seeking to have the Company unbundle the various components of Proposal 2 so that shareholders can rightfully vote on each individual provision as mandated by SEC rules.
We cannot support the two desirable governance reforms at the expense of limiting Apple's ability to potentially unlock hundreds of billions of dollars of shareholder value. Importantly, in its current form, voting AGAINST Proposal 2 does not affect the 'majority voting' reform in the short-term, as Board members have already agreed to resign from the Board if they fail to receive a majority of votes cast "for" their election. As a result, we will vote AGAINST Proposal 2 in Apple's proxy and we urge you to vote AGAINST the proposal, as well.
Proposal 2 Is Value Destructive, Impedes The Board's Flexibility, And Does Not Merit Shareholder Support
Your vote is extremely important, regardless of how many shares you own. Apple shareholders of record as of January 2, 2013 are entitled to vote at the annual meeting. Proposal 2 requires the affirmative vote of a majority of the outstanding shares. If you were an Apple shareholder on the record date, you can still vote AGAINST Proposal 2, even if you already voted your shares.
Greenlight is not asking for your proxy card, so please do not send us your proxy card. If your Apple shares are held in your own name, please vote AGAINST Proposal 2. If you hold your Apple shares in "street name" with a bank, brokerage firm, dealer, trust company or other nominee, only they can exercise your right to vote with respect to your shares and only after receiving your specific instructions. IT IS CRITICAL THAT YOU PROMPTLY GIVE INSTRUCTIONS TO YOUR BANK, BROKERAGE FIRM, DEALER, TRUST COMPANY OR OTHER NOMINEE TO VOTE "AGAINST" PROPOSAL 2. If you have any questions about voting your Apple shares, please call our proxy solicitor, D.F. King & Co., Inc., toll-free at (800) 949-2583 (banks and brokerage firms should call (212) 269-5550), or email email@example.com.
Thank you for your consideration and support.
David Einhorn Greenlight Capital