Latepost Fiscal Alchemy: David Einhorn’S “Value” Play For Apple

If yous are an Apple stockholder, yesterday was an eventful day. First, yous had David Einhorn becoming to a greater extent than “activist” amongst his Apple holdings, moving from existence but bullish on the stock to pushing for change. Second, Einhorn also unveiled his conception for Apple: the fellowship should give its stockholders preferred shares inwards the company, amongst a 4% dividend yield. In pushing for the change, he is quoted equally proverb that doing together with so volition “unlock billions of dollars inwards value".

There volition move NO value created.. none.. 
Before I aspect at the merchandise off on together with the alternatives to the preferred stock issue, permit me dispense amongst the 1 part of his claim that cannot hold. Issuing preferred stock volition non add together value to the company, non 1 cent. Before I teach defendant of existence a “theorist” or “academic” (which I right away know are code words for much worse insults), permit me explicate my rationale:

1. The commencement police pull of thermodynamics, applied to value: You cannot create value out of null together with giving preferred stock to your mutual stockholders is a “nothing” act, equally far equally the value of the fellowship is concerned. It volition non growth the cash flows from operations nor volition it alter the adventure inwards Apple’s business. 
2. The cost of working capital missive of the alphabet volition non change: This activity volition non alter the cost of capital. At commencement sight, it looks similar it should since the cost of preferred stock, at 4% (assuming that it trades at par) is much lower than Apple’s electrical current cost of equity (which I estimated at 12% or higher). However, that savings is a mirage, since mutual stockholders volition right away direct keep to toll inwards the adventure of the additional commitment that has to move met (the preferred dividend) into the cost of equity. If this were non true, every fellowship amongst a good for yous cash catamenia (Coca Cola, Microsoft, Google) could move a coin machine, granting preferred stock to its mutual stockholders. 
3. The constant PE ratio is a myth: The most cringe worthy declaration that I read yesterday was the 1 that went equally follows: Apple currently trades at a PE of roughly 10.2, $450/share on earnings per part of $44. If yous grant each mutual stockholder a $100 preferred stock, amongst a dividend of $4, your earnings per part volition driblet to well-nigh $40, together with preserving the same multiple volition generate a value per part of $400. Add that on to your preferred stock that is worth $100 together with yous direct keep valuation magic: yous direct keep created $50 inwards value. This is the worst sort of nonsense, since it is nonsense amongst a believable twist to it, together with that is why it has been investment conman’s favorite tool over history. The PE ratio is non a constant, together with it volition alter equally yous alter the nature of your equity adventure or cash flows, equally yous are inwards this case. 

Bottom line: If Apple’s part were trading at fair value today (let’s say, at $450/share) together with each Apple shareholder were granted a preferred share, amongst a preferred dividend of 4% together with human face upward value of $100, hither is what the shareholders volition terminate upward asset tomorrow: a mutual stock amongst a value of $350 together with a preferred part amongst a value of $100.

But the toll MAY move affected
While I would challenger Mr. Einhorn's claims of "value creation", permit me select a to a greater extent than charitable stance of what he is trying to do. Perhaps, he is trying to unlock the “price’, rather than the value, a distinction that may brand to a greater extent than feel if yous read my post service on value versus price from yesterday. To brand this "unlocking price" argument, yous direct keep to non alone assume that the stock is nether valued (which I would support) but that the nether valuation is occurring for a rattling specific reason. It is non because investors are misjudging the value of Apple’s operations but because they are non giving Apple credit for either its huge cash remainder ($130 billion +) or its capacity to generate huge cash flows ($30-$40 billion/year), for 1 of ii causes:

1. There could a trust discount attached to the cash balance, because investors are worried that Apple mightiness move tempted to exercise something stupid amongst the cash, together with amongst this much cash, in that location is alone 1 activity that tin exercise yous meaning harm together with that is overpaying on a genuinely large acquisition. 
2. Investors may fearfulness that spell the cash builds upward inwards Apple, they may never encounter the cash, because managers are together with so attached to it that they volition non permit move or because it is trapped together with hence unavailable for user, due to revenue enhancement reasons. 

If investors are discounting cash for 1 or both of these reasons, the preferred stock may serve to growth the toll because it commits Apple to returning the cash (in the assort of preferred dividends) inwards perpetuity. Presumably, “relieved” investors volition right away breathe a sigh of relief together with take away the discount on cash, causing the stock toll to move up. The upside is express to the discount on the cash. Even if cash is existence treated equally worth null today (which would move a 100% discount), that would interpret into $140/share.

Even if nosotros select this argument, though, it is non clear that granting preferred stock to mutual stockholders is the optimal means to create this commitment. In fact, in that location are iii alternate routes that the fellowship tin go:

1.  Increase mutual dividends: The simplest together with to the lowest degree involved alternative is to growth the mutual dividends per part from the existing grade of $10.60 per part to a higher value. In fact, if yous are looking at granting a $100 preferred stock amongst a 4% dividend to each mutual stockholder, yous could create an almost equivalent commitment past times but raising dividends per part past times $4/share. I know that the commitment is a trivial weaker, since mutual dividends are non guaranteed, but given how pasty mutual dividends are (healthy companies rattling seldom cutting mutual dividends), but non past times much. In fact, since investors tend to create inwards expectations of growth into mutual dividends that volition non teach built into a perpetual preferred share, the cyberspace commitment effect may genuinely move neutral. 
2. Buy dorsum stock or pay a exceptional dividend: If investors distrust yous amongst cash or are discounting it, the best reply is to provide inwards correct now, rather than commit to provide it to the future. The job for Apple, though, is that a large chunk of the cash cannot move touched unless Apple decides to pay the “differential tax” (between the unusual revenue enhancement charge per unit of measurement together with the the US revenue enhancement rate) on the trapped cash (estimated to move $80 billion+ of the cash balance). With Apple’s cash balance, though, yous could nonetheless set together a substantial buyback ($40 billion) together with commit to to a greater extent than buybacks inwards the future. 
3. Issue bonds: Instead of giving mutual stockholders shares of preferred stock, yous could give them Apple bonds instead. The payoff of doing together with so is that yous could right away potentially direct keep a value impact, non because your operations direct keep magically move to a greater extent than valuable but because the regime inwards its wisdom allows yous to subtract involvement expenses for revenue enhancement purposes. Thus, if yous were able to give each mutual stockholder an Apple bond amongst a human face upward value of $100 together with an involvement charge per unit of measurement of 3% (unlike the preferred stock, yous cannot arbitrarily laid involvement rates at whatever grade yous want, since the revenue enhancement authorities volition object), the potential value of the revenue enhancement exercise goodness per part , using a marginal revenue enhancement charge per unit of measurement of 40% together with a cost of working capital missive of the alphabet of 12%, tin move computed equally follows:

• Interest revenue enhancement savings each twelvemonth = $3 (.40) = $1.20 
• Present value of these savings inwards perpetuity = $1.20/.12 = $10/share 
• The commitment to brand involvement payments is far stronger than the commitment to pay preferred dividends, since the effect of failing to brand involvement payments is default. That is why in that location is a bound to how many bonds yous tin issue, earlier the merchandise off starts to piece of work against you. 

Faced amongst these 4 choices: the Einhorn preferred stock grant, an growth inwards mutual dividends, a stock buyback/special dividend together with bond issuance, in that location is 1 terminal consideration to move along inwards mind. The mutual stockholders inwards Apple direct keep to intend well-nigh the consequences of each of these for their personal taxes. With the mutual dividends together with buybacks, nosotros are on familiar dry ground together with the effect on taxes is straightforward. Dividends volition move taxed at the 20% dividend revenue enhancement charge per unit of measurement for most private investors, equally volition the working capital missive of the alphabet gains that arise from a buyback together with are closed to equivalent (though in that location is a revenue enhancement timing choice embedded that gives the latter a slight advantage). With the granting of preferred stock or bonds to existing stockholders, in that location is an added revenue enhancement twist to consider. The preferred dividends volition teach taxed at 20% whereas involvement income from bonds is taxed at the ordinary revenue enhancement charge per unit of measurement (higher than 20% for most investors), giving preferred dividends an payoff over bonds (but non over mutual dividends/buybacks). In addition, from my express agreement of revenue enhancement law, the grant of bonds volition move treated equally income at the fourth dimension of the grant whereas the grant of preferred stock volition not. (Thus, the Apple stockholder who receives a $100 Apple bond volition move treated equally having income of $100 inwards the twelvemonth of the grant, whereas the receipt of $100 inwards preferred stock volition but reallocate the ground for the Apple stockholding). 

Bottom line: If the objective behind the preferred stock is to take away the “trust” or the “trapped” discount on cash, why create a complicated mechanism, when a uncomplicated 1 volition do? Just rear mutual dividends, if yous exercise non wish to opened upward the door to debt at the moment, but move out that door ajar for the future.

Preferred Stock: The Big Picture
Contrary to many reports that I read yesterday, preferred stock is neither widely used nor is it favored past times mature, non-financial service companies together with for proficient reason. It brings many of the disadvantages of debt into a fellowship (the fixed commitment, albeit amongst lesser consequences for failure to pay) without the revenue enhancement benefit. In fact, in that location are iii large users of preferred stock together with Apple does non tally into whatever of the iii categories:

1. Control freaks: The occupation of preferred stock is widespread inwards some parts of the world, such equally Latin America, but it takes both a different assort (from the US preferred) together with oft has a different motive. In much of Latin America, preferred stock does non title yous to a fixed absolute dividend but instead gives yous a commencement claim on the dividends together with a pct of the profits. Thus, these preferred shares are genuinely mutual stock without voting rights. They are used past times companies, where insiders concur the voting shares together with direct keep no wish to move accountable to the working capital missive of the alphabet markets. 
2. Young together with start-up firms: Young firms oft occupation preferred stock to rear working capital missive of the alphabet because they wish to rear capital, without diluting the existing owners’ stakes inwards the companies. For these companies, the revenue enhancement benefits of debt are irrelevant inwards the conclusion process, since they are oft coin losers, together with the adventure of default is besides high. To sweeten the pot for investors, they volition oft add together the choice to convert into equity to the preferred stock (creating convertible preferred shares). 
3. Financial service firms: Financial service firms occupation preferred stock because some measures of regulatory working capital missive of the alphabet allow them to count preferred stock equally part of capital. Thus, spell they stance preferred stock equally expensive debt (since it does non direct keep the revenue enhancement advantages), it does serve the operate of augmenting regulatory capital. 

Studies of both the US together with European companies suggest that when CFOs are asked well-nigh their preferences on raising funds, in that location is a financing hierarchy. Topping the listing equally most favored is straight” debt together with at the rattling bottom of the listing is preferred together with convertible preferred. For non-financial service firms, the issuance of preferred is to a greater extent than a sign of desperation than it is of health. No thing what yous intend well-nigh Apple’s prospect, I don’t intend yous would stance them equally existence desperate for novel working capital missive of the alphabet correct now.

Generalizations
If David Einhorn’s thought is a non-starter when it comes to value creation together with non particularly effective fifty-fifty equally a toll catalyst, he is non lone inwards his sales pitch. In fact, what he is doing is widespread amid companies, consultants together with banks together with I would suggest iii changes inwards the means restructuring plans/ proposals are presented to investors together with public.

1. Stop using toll together with value equally interchangeable terms: Much of what passes for value creation inwards many companies is non what it is made out to be. I direct keep seen the hue together with yell about stock splits, issuing tracking stock together with accounting restatements of assets on remainder sheets together with wondered why nosotros brand such a large bargain well-nigh these actions. All of these tend to move purely cosmetic together with direct keep no effect on value. However, they could impact stock prices, if in that location is a gap betwixt value together with price. So, let’s require truth inwards advertising. 
2. When yous beak well-nigh value enhancement or creation, move specific: If an investor, fellowship or consultant claims that an activity volition rear value, the onus has to move on the claimant to explicate where the value growth is coming from. Simply put, it has to come upward from increasing cash flows inwards existing assets, reducing the adventure inwards these cash flows, improving the revenue enhancement benefit/default adventure merchandise off or from growing to a greater extent than efficiently (improving competitive advantages). That is a broad sheet together with every truthful value enhancing activity has to wend its means through 1 of these paths. 
3. If yous are talking well-nigh toll enhancement, order so: If yous believe that taking an activity volition growth your toll (and has null to exercise amongst value), don’t claim otherwise. Here again, move specific well-nigh what marketplace fault or friction yous are exploiting. If at the limit, your declaration is that the toll volition move upward because investors are naive or stupid (which is the ground for the constant PE argument), yous mightiness equally good order so. 

In closing, I am glad, equally an Apple stockholder, that David Einhorn is rocking the boat, fifty-fifty if I intend his proposal is the non the most effective catalyst or game changer. It opens the door to a good for yous give-and-take well-nigh how Apple should bargain amongst its large together with growing cash balance, together with that is a proficient thing for all concerned.

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