Recent noises made by a hedge fund manager (David Einhorn) requesting extra cash distribution to Apple (AAPL) shareholders via the issuance of preferred shares is misleading, risky and technically wrong.
After the announcement that Greenlight has sued Apple and the inclination of Apple's senior management to review Greenlight's proposal, share price has rallied to $480. So far, the market has reacted positively to the issuance of preferred shares. But is this reaction justified? How is it possible for asset stripping to lead to a share price rally?
The explanation and the mystique around this idea are simple:
· Existing established dividend remains intact. As such, shareholders continue getting a ~2% dividend and the existing stock leverage is maintained.
· In addition to existing distribution, shareholders will receive an extra $2 billion per year via the issuance of preferred shares.
By using current P/E multiples (~10x), a $2 billion distribution corresponds to the issuance of $50 billion of preferred shares ($2 billion x 10). This in turn, corresponds to 4% dividend ($2 billion/$50 billion). By taking into account the number of existing outstanding shares, the fair value of each new preferred share should be $53 ($50 billion/939 million shares).
As a result of the new issuance, the value of Apple's existing shares must drop accordingly due to dilution (more shares, albeit a different class, but no corresponding asset increase). By using the same P/E multiple (10x) and the new $42 EPS ($44.15 - $2.15), the fair value for Apple should be $420.
By simply adding the fair value of the common and the preferred shares, we get Apple's fair price -- i.e., $473 ($420 + $53). This share price is not far away from current price.
But who really benefits from this alchemy? Are there other possible alternatives that do not engineer value by dislocating risk?
Let's see all the possible options:
· Existing dividend is increased by 50%-100%. Under this approach, cash distribution increases by $4 to $8 billion.
· Issuance of a 2% special dividend in addition to the existing dividend. Existing dividend and special dividend offer to shareholders the same return as the increased regular dividend.
· Rights issue is another option. The subscription price could be set at a suitable discount rate (5%-10%) that effectively offers shareholders the same yield as the preferred shares, after taking into account cost of funding and dilution.
· Finally, preferred shares. Preferred shares usually pay a fixed dividend, rank higher than common shares, lack voting rights and might not appreciate as much as common shares.
There is one more option: share buybacks. Since this option is an existing practice, it will not be discussed further.
The first scenario does not engineer value (although it is possible that Apple shares will trade higher due to extra available leverage), and does not alter the existing risk distribution among shareholders. As such, investors (short or long term) must remain relatively indifferent. The second scenario benefits from the same dynamics and therefore, investors remain indifferent again.
The third scenario is not the best option for the short-term investor (e.g., hedge funds) due to the associated cost of capital and prevailing market conditions at the time of issuance. The long-term investor should not be troubled, since this is an opportunity to buy Apple's stock at a discount. Cost of capital is a concern, but the nature of the investment justifies the move. This scenario, as the other two discussed hitherto, does not alter the risk distribution that shareholders have subscribed to.
The last solution, however, is different. This scenario is the worst possible one for the long-term investor, but the best one for the short-term investor. The reasoning is simple:
· No upfront capital. Shareholders need not seek funding. Shares are distributed for free.
· Accounting returns can be astronomical, and can provide a huge boost to performance-based institutions (e.g., hedge funds).
This solution is a no-brainer for the short-term investor, but a real headache for the long-term investor. Let's see the reasoning behind that:
· The long-term investor does not plan to sell, therefore, it does not benefit from accounting and mark-to-market tricks.
· A typical long-term investor is a pension fund that seeks low volatility and stable returns. By taking on-board instruments such as preferred shares, the long-term investor is exposed to a variety of additional types of risk that are not observed in common equity instruments.
· Finally, dilution and fundamentals eventually prevail, leading to the unavoidable share price rebalancing (hopefully not collapse). At that point, alchemy disappears, and long-term investors must deal with the consequences.
All the above points lead with a mathematical certainty to the following conviction: long-term investors, unlike short-term investors, are susceptible to correlation and wrong-way risk that are associated with higher leverage, debt-like instruments, such as preferred shares.
Preferred shares exhibit high correlation to the corporate entity (Apple in our example) that is responsible to service them. In the event that the corporate entity responsible shows signs that servicing preferred shares in perpetuity is hindered, the associated value of the preferred shares will collapse overnight. This is a clear example of wrong-way risk that stems from the fact that debt (or debt-like) instruments are adversely correlated to the credit quality of the entity issuing the debt. Accepting wrong-way risk in this low interest rate environment and committing for the next 5, 10 or more years is a casus belli for the long-term investor, or indeed, for any retail investor.
Let's assume that Apple's perceived credit quality deteriorates. Common shares may not suffer, since equity investors will pay attention to a variety of factors, including fundamentals and technicals. The preferred shares, however, will suffer the most. Due to the perceived lower credit quality of the issuing entity, preferred shares will immediately start trading at a discount. Yield will most likely rise to anything between 6%-8%, or even higher. At the 6% scenario, investors will lose ~30% of their investment. At the 8% scenario, investors will lose 50% of their investment. This type of leverage associated with preferred shares is absent in common shares, and as such, low-risk investors may conclude that high leverage instruments are not suitable for them.
Obviously, this wrong-way scenario may not materialize; i.e., Apple's earnings might go higher and higher, and Apple's perceived credit quality might improve. In this positive scenario, preferred share yield will go down, and investors will benefit accordingly.
Since, however, a prudent investor tries to achieve portfolio optimization by balancing the risk reward ratio, the acceptance of preferred shares in a very low interest rate environment is a risk that is not justified.
The issuance of preferred shares is not the optimum solution towards better use of existing cash reserves, and it does not serve all shareholders equally well. Post issuance of preferred shares, risk distribution will be altered, with long-tem investors absorbing a disproportionate amount of risk. Short-term investors can always offload the risk by selling immediately after the issuance of preferred shares. My conviction is that all short-term investors will dump preferred shares in no time.
Apple's excessive cash reserves can be put to better use for everyone by:
· Increasing the existing dividend by 50% or more,
· Funding sizable and meaningful acquisitions,
· Funding organic growth,
· Investing in the supply chain, and
· Investing in near-proximity manufacturing.
Finally, it is worth noting that only one-third of Apple's cash reserves are held domestically. Remaining cash is overseas, and any attempt to repatriate these funds will be accompanied by a substantial haircut due to taxes.
Issuance of preferred shares is the best possible solution for the short-term investor. There is no requirement to put capital at risk, and the returns can be substantial. The long-term investor must endure correlation and wrong-way risk. This is a risk that is unnecessary, and can be avoided by alternative capital distributions and investments.