I have been a big fan of Apple (NASDAQ:AAPL) and I don't always agree with David Einhorn. I bet against him on Allied Capital and made a bundle on the debt of Allied Capital - now Ares Capital (NASDAQ:ARCC) - symbol AFC. But I think he has made a good point about AAPL.
First, let's sort out the dispute. AAPL has a proxy statement out which includes changes in its corporate documents supported by management. These changes would, among other things, take away the unfettered discretion of the Board of Directors to issue preferred stock. Certain arcane versions of preferred stock can be issued in the middle of a takeover fight and can serve as a powerful takeover defense. AAPL's current provision giving management the right to issue virtually any kind of preferred stock it wants to without shareholder approval could facilitate that kind of defense. AAPL's management seems to feel that the continuation of that kind of provision is not warranted. As a general matter, AAPL's management is taking a position that is generally regarded as shareholder friendly. This proposal is included in a resolution including other matters - the election of Directors and the par value of the stock.
Einhorn wants AAPL to issue preferred stock as a means of rewarding shareholders. Greenlight Capital's website has a general description of the provisions of GO-UP (Greenlight Opportunistic Use of Preferreds) preferred stock which could be issued to "unlock" shareholder value in undervalued cash rich companies. The preferred stock would be "perpetual" (like many student loans may turn out to be) in that it will never mature and AAPL will never have to repay the principal. It would have a liquidation preference over common stock but that would come into play only in the very unlikely event of a bankruptcy. It would pay a dividend of 4 percent and would presumably be priced in $25 units with each unit paying $1 per unit in annual dividends.
Management's proxy proposal would not preclude the issuance of the dividends described above but shareholder approval would be required for their issuance if the proposal passes. On the other hand, the defeat of the management proposal will not necessarily lead to the issuance of the preferred stock either. Even if the proposal is defeated, the Board would still have to agree to the issuance. Einhorn is opposed to the proxy proposal on the merits and also because it "bundles" three separate matters in one proposal which is, Einhorn contends, a violation of SEC rules.
1. The Big Issue - Shareholder Value
The big issue here is whether AAPL is acting in a way to maximize shareholder value. A good case can be made that it isn't. It has piled up a huge amount (roughly, $137 billion) of balance sheet cash on which it earns roughly 1% pre-tax. I have pointed out in a previous article that AAPL is really two companies - a very good technology company and a very bad money market fund. The stock price does not really reflect the value of the balance sheet cash (with the cash backed out of market cap, AAPL is trading at a ridiculous 7.3 times earnings) and so a strong argument can be made that something else should be done with the cash - which increases every quarter - to benefit shareholders. A case can be made that the technology business is volatile and investment intensive and that a large "war chest" is prudent. But, during a period of robust growth, AAPL has spent $21.7 billion on capital expenditures and acquisitions over the past 4 years. $137 billion is enough to fight several wars and then some.
AAPL has recently announced a plan to return roughly $45 billion to shareholders over the next three years in the form of dividends and share repurchases, but cash is building up at a much faster rate than $15 billion per year (more in the neighborhood of $40-45 billion per year). A very good case can be made for a more robust effort to use the cash to benefit shareholders.
2. The Preferred Stock Proposal
Let's first look at the merits of the preferred stock proposal. Einhorn suggests that AAPL initially issue $50 billion face value of the preferred stock (2 billion shares at $25 face value per share) paying a dividend of $1 a share or 4% of face value and "test" the market; he assumes that the stock would trade at a discount to produce a price of roughly $16 a share. He anticipates the issuance of additional preferred stock once the market is tested.
Assume that AAPL ultimately issues 10 shares of the preferred stock for every share of AAPL common stock. If you own 100 shares of AAPL, you would receive 1000 shares of preferred with a face value of $25 a share. You would receive an annual dividend of $1000 in addition to the dividend on the common. You could sell the preferred and keep the common and the preferred might trade at a discount to par - let's accept Einhorn's estimate of $16 a share. For each share of common you now own, you could obtain something like $160 by selling the preferred.
The common would likely become less valuable but how much less valuable? The preferred dividends would cost AAPL some $9.5 billion a year but AAPL has $137 billion in balance sheet cash and generates $40 billion or so per year in cash flow. Common dividends now cost about $10 billion a year so there would still be plenty of cash flow even after the preferred dividends. Common would dip but it would not likely dip by $160 a share - at $340 a share AAPL would have a dividend yield of 3% and could bump its dividend up nicely each year for a very long time. It's hard to see the price going much below that level and at that level, the shareholder who sold his preferreds for $160 would come out ahead of Friday's closing price of $474.98, but not by much. Of course, common might dip less and that presumably is one of the things that the initial $50 billion face value issuance would "test".
There are a number of solutions to the "no credit for balance sheet cash" problem - share repurchases, higher dividends on common stock, a one-time large dividend, and the issuance of preferred stock or bonds to shareholders. The optimal choice depends to some extent on the objective. In AAPL's case, one problem is the "too large a market cap" problem, another problem is shareholder need for cash (probably primarily by AAPL employees owning large amounts of stock) and the third problem is too low a valuation in the market.
The first problem is hard to assess. Certainly, there are some large institutions which may limit the percentage of total holdings that can be devoted to one company and may therefore have to periodically sell AAPL stock. In addition, if the market "believes" that there is a kind of "maximum market cap" glass ceiling, it could become a self-fulfilling prophecy and create a kind of roof on the price regardless of the merits of the belief.
I really don't know much about the second problem but I would look to AAPL's management to determine the solution which best served the interests of employee/shareholders.
The low market valuation problem can generally be resolved by using undervalued balance sheet cash to create either a higher price or cash in the hands of shareholders.
I tend to base my decisions upon private market value and so I would favor the approach which would increase the private market value held by AAPL shareholders. Dividends and the issuance of new preferred shares do not really accomplish this - in this regard, they resemble the "rearranging the deck chairs" solutions in that they simply move around existing assets. On the other hand, share repurchases tend to increase per share earnings and increase the private market value of one share by making one share a larger percentage of the total company. Repurchases also help to solve the "too large market cap" issue by allowing the share price to rise without increasing the total market cap due to a lower share count. If you agree with me and think AAPL is grossly undervalued, then share repurchases are compelling.
On the other hand, perpetual preferreds are an ingenious solution to this problem. They never require payment of principal. They are not carried as liabilities on the balance sheet. Preferred dividends can be deferred in the event of severe cash flow problems.
AAPL is already paying a dividend (which I am sure it will increase each year), and AAPL is already implementing a buyback program. Einhorn's proposal should be tested with a small issuance. At the same time AAPL should commit to increasing its dividend between 10 and 20% each year until it reaches $20 a share and should commit to a buyback program aimed at reducing share count by at least 1% per year. These three programs should be periodically reassessed by AAPL's board.
4. The Proxy Statement
Einhorn has unnecessarily confused the shareholder value issue with the issue presented in the proxy statement. I tend to agree with management on that issue but I would not like my vote in favor of management to be construed as disapproval of Einhorn's basic proposal. In case matters were getting too simple, there is also the "bundling" issue on which I think Einhorn may have a point. Fortunately, I am used to this kind of dilemma because, as a Reagan Democrat, I face it every two years in the ballot box. I am not sure how I will vote. On the other hand, I will support proposals to generate shareholder value and I think that the preferred stock proposal is fundamentally sound and should be implemented - at least to the extent of the initial $50 billion face value issuance.
5. Investment Implications
The ongoing public debate about what to do with all that cash and the constant statements that AAPL is undervalued in the market, as well as the anticipation that AAPL will embark on one or more of the above strategies, will tend to be bullish for a stock which is already undervalued. This is not a bad time to buy AAPL. Needless to say, I am long AAPL.