Slicing and Dicing the Apple

AAPL rose Thursday when a hedge fund called for cash payouts on new preferred shares.

On Thursday Apple investor David Einhorn filed a lawsuit to defeat Apple's shareholder proposal that would make it more difficult to issue preferred stock. Mr. Einhorn believes that a new issue of preferred will enhance total shareholder returns more than other actions, such as simply raising the common stock dividend.

Sidebar: preferred stock is commonly viewed as a hybrid security having characteristics of both debt and equity. Like debt, it usually carries a fixed coupon and has priority above common stock in cash distributions. Like common stock, there is no "principal" to be repaid by a certain date and no legal obligation to pay dividends, which may be suspended if the board decides (the unpaid dividends accumulate and normally must be brought current before common dividends can resume, however). The income tax treatment of preferred stock dividends is the same as common stock, both for payor and payee.

In Mr. Einhorn's estimation, Apple preferred will be snapped up by fixed-income investors, that is, many of the same people who buy bonds.

Assuming a 5% yield, a preferred security from Apple that paid $2 billion in total annual income would have an implied market value of $40 billion. Thought of another way, it would sport an earnings multiple of 20 times.

This is where we need to get out our sharp pencil. Apple's market capitalization at today's closing price totaled $446 billion ($474.98 x 939 million shares). In theory that amount represents the market's calculation of the present value of all cash flows that common shareholders will receive in the future, discounted at a rate appropriate to Apple's risk. Mr. Einhorn thinks that that discount rate is too high and penalizes Apple's valuation.

If we follow the example in the WSJ article, preferred shares with an annual payout of $2 billion will be worth $40 billion. The $40 billion isn't coming out of the air: there will be $2 billion per year that will no longer be available to the common shareholders at some point in the future (the current dividend of $10.60 per year won't be reduced and is very safe). In theory the value of the common shares will go down because the new preferred skims off the least risky equity cash flows, but the drop should be much less than the $40 billion added by the preferred.

[Update - 2/9 from Barron's: "We think for every $50 billion of preferred that Apple issues, it would unlock about $32 a share in Apple," Einhorn told CNBC. He seems to be saying investors would get $50 of preferred and see the common fall about $18 a share.]

We have seen this act before. In the heyday of securitization sharp financiers sliced and diced the cash flows. They issued a multitude of debt securities that were assigned low discount rates (and high prices) by a marketplace that misapprehended risks and relied on fallible rating agencies to evaluate them properly. Through financial legerdemain the sum of the new securitized parts was worth more than the original whole, even after generous fees were paid to Wall Street. After the financial collapse, many of the securities, even some with an AAA rating, became worthless.

True, it's unlikely that there will be negative consequences if Apple does go ahead with a preferred stock issue, but why take that risk and complicate matters? If bulls are correct, eventually the market will come to its senses and assign a higher price to Apple common shares, although not as quickly as hedge fund managers like David Einhorn would like.

Speaking as an individual little-guy investor, I say let Apple's finances be clean and simple, just like its products. © 2013 Stephen Yuen