How David Einhorn’s Apple Preferred Stock Proposal Works

by JT McGee

There’s lots of chatter about David Einhorn suing Apple over their capital allocation policies. As I’ve written fairly recently, I think Apple is a terrible capital allocator. I’m not the only person who thinks so.

Here’s what Einhorn wants to do to unlock shareholder value:

  1. Apple should pay out a preferred stock dividend to shareholders.
  2. The preferred stock would yield 4% in perpetuity (forever.)
  3. Based on Einhorn’s numbers, he thinks every $50 billion of preferreds would unlock $32 per share in Apple. Running the hp12c on that one says…basically, he expects the preferreds to trade at a yield of 6.58%.

Ultimately, Einhorn thinks Apple should dedicate half of their earnings to paying for the newly-issued preferred stock. The result would be $500 in face value of Apple preferred stock yielding 4%. In market value, Einhorn thinks the preferreds will be worth $320 per share (again going back to the fact he thinks these will sell at a yield of 6.58%). Alternatively, Apple shareholders can enjoy the $20 in annual preferred dividends paid out each year.

Why this has legs

Einhorn’s proposal does three things:

  1. It assumes that the market has discounted significantly the value of Apple’s cash because investors have no idea when it will be returned. (FWIW, I completely agree with this assumption.)
  2. It plays on the fact that yields are ridiculously low and the appetite for high quality bond and preferred stock issues is exorbitant.
  3. It benefits people who want a higher annual dividend (just hold the preferred stock, in that case) and the people who want a one-time special dividend (just sell the preferred stock once it’s issued to you).

Basically, Einhorn’s hoping that he can encourage Apple to engage in a program that will create money from thin air. The hope is that the market value of the preferred stock plus the market value of the common stock will be greater than the current market value of the common without preferreds.

If Apple shareholders see a plan for the return of the cash on the balance sheet, they should be more eager to pay for that cash. Additionally, by “selling” the cash in a preferred, Einhorn hopes to multiply the benefit by tapping investors who are CRAVING yield and willing to pay a premium for it. Finally, Einhorn’s plan allows for Apple to slowly remove cash from the balance sheet, allowing the company a cushion while still having a plan to return cash to shareholders.

All in all, I completely dig the plan. I think it’s a little overcomplicated – repurchases/dividends work, too – but anything that gets people talking about returning cash to shareholders is favorable for all.

{ 5 comments… read them below or add one }

Brick By Brick Investing | Marvin February 8, 2013 at 12:04

I have pounded my fist on the table for years about this topic! People have gone Gaga crazy over Apple and I don’t know why. I’m sure its awesome to be an employee but as an investor I don’t think so. They are awful capital allocators as you pointed out. It wasn’t until recently that they offered a dividend which in my opinion is a joke, they have a mountain of cash and could return so much more to their investors through dividends or share buybacks.

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JT McGee February 9, 2013 at 16:49

I think it’s easy for investors to forget about retained earnings when the future earnings are the only thing everyone cares about. Now that Apple’s at the point where they’re either going to grow marginally year over year or even shrink in size (low P/E seems to indicate so!), the cash on hand is going to be a pretty big deal. I agree with returning it, because, frankly, it’s just the right thing to do, and it makes perfect sense for shareholders.

Nothing like a haircut from $700 to $450/share to get people thinking!

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Ken Faulkenberry February 8, 2013 at 18:15

Great analysis and explanation J.T. Personally, I think they should just double the future dividend. They can safely do this with the amount of cash they have. This would have the same effect on the stock price without all the “shenanigans”.

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JT McGee February 9, 2013 at 16:51

Yeah I don’t see a problem with simply increasing the dividend, either. Issuing preferred shares does create a cash flow risk, especially if they go full tilt and issue $500 billion of them.

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Sarah Park February 9, 2013 at 02:20

Very fair analysis. Apple should be fair enough with their investors and give back what they should be giving. They are earning a bunch of cash but do not give enough compensation.

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