David Einhorn is Wrong on ‘iPrefs’

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Shareholder activist David Einhorn has made headlines in recent weeks arguing that Apple (NASDAQ: AAPL) can unlock shareholder value by issuing $236 billion in preferred shares. But this financial engineering doesn't create any new wealth, and actually harms the company in the long-term. Apple shareholders should dismiss Einhorn’s 'silly slideshow' and ignore these types of financial shenanigans

In theory…

Einhorn's proposal is to create a new class of preferred stock that would be distributed to existing shareholders, paying a 4% dividend indefinitely. Einhorn believes this plan could unlock $150 billion in shareholder value.  But let's put on our i-Banker suits and see how the proposal would work in theory.

The value of a business is determined by the company’s future cash flows discounted by an appropriate interest rate.

<img src="/media/images/user_14324/aapl1_large.png" />

Here's how Apple is roughly valued today.

<img src="/media/images/user_14324/aapl-revised4_large.png" />

The problem with Apple, in Einhorn's view, is that the company is sub-optimally financed by expensive equity. Investors discount future cash flows at a high rate, reducing the value of the firm.

Preferreds are advantageous because they're cheaper to issue than equity. Preferred shareholders will accept a lower return because yields are fixed and they're first in line to receive any dividends. 

<img src="/media/images/user_14324/aapl2_large.png" />

By issuing $236 billion in preferreds, Apple can reduce its cost of capital, lower the rate cash flows are discounted, and increase the value of the firm.

<img src="/media/images/user_14324/aapl-revised3_large.png" />

Amazing! Using the super computing power of a napkin, I’ve created $150 billion. Somebody call Harry Potter, because I just found the Philospher's stone.

Precedents

No other technology company has ever issued such a large block of preferred shares. However, other industry names are taking advantage of the low interest rate environment to enhance shareholder value.

Microsoft (NASDAQ: MSFT) has issued $2.2 billion in long-term debt to fund its dividend and share buyback program. Last November, Microsoft sold $600 million worth five-year notes at 0.88%, $750 million of 10-year bonds at 2.13%, and $900 million 30-year bonds at 3.5%. 

Even Amazon (NASDAQ: AMZN) is getting in on the action. Last fall, the company issued $3 billion in debt is finance the purchase of its Seattle headquarters. Amazon sold $750 million three-year notes at 0.65%, $1 billion five-year notes at 1.2% and $1.25 billion of 10-year bonds at 2.5%.

Incredibly, Microsoft and Amazon were able to raise these funds for only a few basis points above comparable U.S. Treasuries. Expect companies to continue to take advantage of record low interest rates by funding their operations with debt. 

…but here’s the problem

Unlike debt, issuing preferred shares doesn’t reduce Apple's cost of capital. As Apple increases its funding through preferreds, the cost of equity will rise proportionally to compensate for greater risk. As a result, the $150 billion in value creation Einhorn claims is fictitious. 

This was the same logic used to create toxic mortgage products during the housing bubble. In theory, mixing sub-prime loans with AAA securities raised the quality of junk bonds in the portfolio. In reality, the sub-prime loans only diluted the quality of the entire pool.

Other issues

There're other problems with Einhorn’s proposal:

Funding: Issuing $236 billion of preferred shares would require an additional $9.5 billion in dividend payments. This would significantly crimp Apple’s ability to fund new projects and impair the long-term viability of the company.

Taxes: The new preferred dividend would quickly exhaust the company’s domestic cash holdings. This would require Apple to repatriate foreign reserves, resulting in a big tax bill.

Liquidity: Standard & Poor’s estimates the size of the U.S. preferred market to be worth $214 billion. Einhorn’s proposal would more than double the size of this market while assuming a 4% yield. Yes, interest-starved savers would initially line up for iPrefs, but such a large issue would be more costly than assumed.

Foolish bottom line

CEO Tim Cook is deploying capital prudently, and excess cash balances can be drained through traditional means. Until it becomes apparent Apple is squandering shareholder capital on overpriced acquisitions or frivolous side projects, investors should temper their calls for higher dividends or share buybacks. 


RobertBaillieul has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Apple. The Motley Fool owns shares of Amazon.com, Apple, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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