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Does Einhorn's Apple Preferred Stock Push Make Sense?

|Includes:Apple Inc. (AAPL)

Greenlight Capital founder David Einhorn made waves in the financial media last week after he took an activist stance on Apple's (NASDAQ: AAPL). He wants the company to unlock the value of its sizable cash hoard. Einhorn wants Apple to issue perpetual preferred shares to all existing common shareholders. Perpetual preferred shares are a debt-like security that entitles holders to a fixed-percentage dividend based on its face value.

Mr. Einhorn's activism started in reaction to a proposal that Apple had put forth to a shareholder vote, which asked for the elimination of preferred shares from the company's charter. Greenlight has embarked into a campaign to rally other shareholders to oppose the removal of preferred shares.

Mr. Einhorn proposes that Apple issue perpetual preferred stock yielding 4% to all existing common shareholders. Under such arrangement, the company would issue an initial $50 billion in preferred shares to holders of its float. This security would yield a perpetual payment of $2 billion (4% of the face value). Per Einhorn's own assumptions, this security "would allow Apple to take advantage of the market's appetite for yield while preserving future operating and strategic flexibility." Mr. Einhorn's also estimates that for every additional block of $50 billion issued in perpetual preferred stock, Apple would be able to unlock about $30 billion, or $32 per common share in value. Thus, this would ultimately enable Apple to "unlock hundreds of dollars per share".

According to Mr. Einhorn's statements on CNBC and Bloomberg TV last week, as well as Apple's own statement, the company is presently considering his suggestions.

In the meantime, Henry Blodget has weighed in by saying that what Greenlight Capital aims to do amounts to little more than financial engineering. Mr. Einhorn actually took the time to reply to Blodget's take, resulting in an email chain that should not be missed, both for the spectatorship effect and the insight into security valuation as well as financial engineering.

While deferring to both above-mentioned gentlemen as sizably smarter and more experienced than I am, I pose several questions that I have upon reading Mr. Einhorn's arguments.

First, let us assume that Apple does go forward and grants each current shareholder. Once each current Apple shareholder has received-free of cost-the proportional share of perpetual 4% preferred stock, what happens to all future/new shareholders? Would perpetual preferred shares exchange hands simultaneously with common shares? If future shareholders are expected to pony up for Apple's enhanced share value, the new preferred shares would have to be handed over to the new buyers of the common shares-hence the unlocked value for all shareholders. This would somehow make the preferred nature of the new security obsolete. If common and preferred shareholders are in fact the same, then this starts to look a lot like a normal common dividend that expands. On the other hand, if they are different--and Mr. Einhorn's language suggests they are--then the unlocked shareholder value not only bypasses common shareholders, but it most likely hurts them. Value unlock would then apply only if Apple kept on issuing new tranches of high-yield perpetual preferred stock.

This brings me to a second question. What does Apple get in return for this perpetual preferred stock? Normally, preferred securities work this way: investors pay a par value, discount or premium to face value based on prevailing yields available elsewhere in exchange for the right to the preferred dividend. Thus, if we ignore the "no cost to shareholders" proposed by Greenlight Capital, Apple would get $50 billion for that initial preferred offering, and $50 billion for each subsequent issue. Instead, if I have understood the proposal correctly, Apple gets exactly nothing in return for signing itself to pay these tranches of perpetual.

If, as I discuss above, preferred and common shareholders were the same, then this would be fine-Apple would get more shareholder-friendly. On the other hand, if preferred and common shareholders will at some point be different, there is the potential for awkward situations. Consider the case of a current common shareholder selling his common shares but retaining his preferred shares. According to Mr. Einhorn's analysis, he would be able to sell common shares at a higher price by virtue of unlocked value. Yet, the new owner of the common shares would not receive the crux of that unlocked value (the preferred), unless Apple kept issuing new preferred shares, at the same or higher yields. If this does not happen, the new owner would have effectively overpaid to be subordinated in his rights toward the company's assets in the future.

Based on the highly complicated nature of what Greenlight capital proposes, I expect that Apple will refuse Mr. Einhorn's proposal. Further, if Apple does choose to do something, it may move in the direction to unlock additional value through either the increase of its current dividend yield, or a one-time special dividend. In my view, this would be the simplest way to boost shareholder value without unduly hampering the company's balance sheet with effectively perpetual liabilities.

I believe there is a third, and possibly a fourth option towards removing the excessive volatility around Apple's common stock.

The company's third option could be the introduction of a dividend policy that is at least partially related to the company's free cash flow performance. Basically, each quarter, the company would distribute a set percentage of the cash flow it had generated. This would present a sound dividend policy, which would not tie the company to a fixed dividend rate in the unlikely but possible scenario that one day it may need to conserve cash.

A fourth option would be a split on common shares. The reason AAPL shares continue to receive an inordinate amount of attention from markets and media is the sheer size in share price and price decline it has suffered in recent years. A 10-for-1 reverse split would effectively make AAPL a roughly $47 per share stock today. Such a split would have made its all-time high valuation roughly $70 per share. At $23 per share, the stock's decline from its high would have been far less a reason for the investor panic and media pandemonium that has followed it.

In closing, I believe that if markets and media seek a culprit for the performance in Apple's share of stock, they (we) need not look any further than our own selves.

Disclosure: I am long AAPL.

Stocks: AAPL