Apple had nearly $137 billion of cash at the end of Dec 2012. Over the past few years, the Company had been highly successful with the launch of the iPhone 3G in 2008, and which was followed by the launch of iPad in 2010. The Company enjoyed high profitability, and was able to keep its costs at a minimum. The gross margin on the iPhone was between 49% and 58% from October 2010 to March 2012, and the gross margin on the iPad was between 23% and 32% in the same time period. Apple’s capital structure included no debt; hence, there was no outflow of cash for making interest payments.
However, in spite of the successes of Apple, the Company’s stock price had been dipping since reaching its high point in September 2012. There was increased competition in the phone and tablet industries due to entry of Android powered devices. Shareholders were also worried that Apple was hoarding large amounts of cash, and was not returning it to the shareholders. The general consensus among investors was that Apple had no new groundbreaking projects to be launched. I think that the shareholders’ perception of the lack of meaningful investment opportunities and that the Company was hoarding large amounts of cash (which the investors cannot trust what it could be used for) led to the discount in the share price, which was also reflected in its low PE multiple.
Tim Cook, CEO of Apple, however, claimed that cash was not being hoarded because shareholders would see the return of cash as a bad sign. Rather, as Steve Jobs had stressed earlier cash was being held for the more strategic opportunities (such as R&D, M&A etc.) that may appear down the road. Another issue with the large amount of cash holdings was that Apple had offshore operations in a large number of countries. The majority of Apple’s cash – approximately 69% or $94 billion – was held up in Ireland and other offshore locations that had a low tax rate. Repatriating any of that cash for paying dividends or share repurchases would attract a repatriation tax that is equal to the difference between the US rate and the local, foreign tax rates. A reason for the high amount of offshore cash was that 61% of Apple’s revenues came from offshore locations.
In March 2012, Apple announced a quarterly dividend of $2.65 per share and a share repurchase plan of $10 billion. However, the stock price continued to fall. David Einhorn, president of Greenlight Capital, suggested that Apple should issue perpetual preferred stock that would pay $.50 quarterly dividend (or $2 yearly) based upon a face value of $50 for each share of the preferred stock. His argument was that issuing preferred stock did not require repatriation of offshore cash as the dividend could be paid from FCF. Each preferred stock could unlock $32 per share in value.
There are several ways in which Apple could deal with the varied choices that it is facing. I believe that instead of introducing a new type of capital such as preferred stock, Apple can steadily increase its dividend quarter by quarter. This will attract new type of investors to the stock i.e. those that seek regular income such as pension funds, retirees etc. Increasing dividend would also signal that the Company is confident of its future growth plans because dividends are somewhat “sticky”. A new type of investor along with greater confidence that Apple might project through its commitment to increase dividends might lead to a boost in the share price. If Apple feels that it needs to return cash right now rather than showing its commitment for the future, it can accelerate its share repurchase plan.
As seen in Exhibit 1 on page 2, Mr. Einhorn has claimed that issuing a $50 preference share would actually lead to a share price appreciation to $480, or an increase of $30 over the current share price of $450. However, as pointed out by Professor Damodaran of NYU Stern, a view to which I also concur with, the PE ratio will not remain constant after the issuance of preferred stock. Common Equity investors might perceive the equity to be more risky now, after all preferred stock have a fixed commitment, and common equity claims are subordinated to preferred. Thus, common equity might itself be treated as more risky, leading to an increased WACC (high discount rate). Thus, there are chances that the entire dynamics of the capital structure would change. Moreover, preferred is a common way of financing for companies in distress and not mature companies like Apple.
In conclusion, Apple should not agree with the proposal presented by Mr. Einhorn. It should either commit to increase dividends and thus the market might slowly do away with the discount that it is placing on its cash. I would suggest that should hoard cash worth one-year of operating expenses and capex at the parent level. The remaining cash can be spent for dividend payments. I would not like Apple to go for a one-time special dividend as it does little to create long-term perception of value creation (it might lead to a one-time pop in the share price). Alternatively, Apple might also go ahead with an accelerated share repurchase plan.
Exhibit1: How iPrefs Work (Source: Greenlight Capital presentation)
Note that is assumed that $2 dividends will decrease common stock earnings by $2 i.e from $45 to $43 (FY 2012 EPS is $44.64). However, PE ratio would remain the same i.e.10.0x even after taking the riskier capital structure into consideration, which I think may not be the most correct assumption.