Einhorn is unhappy with Apple’s $137 billion cash hoard on the balance sheet and wants Apple to issue perpetual preferred shares to enhance shareholder value. He said in an open letter that every $50 billion of preferred shares it distributes (at 4% rate) will increase value to Apple shareholders by $32/AAPL share.
First of all, I noticed that there were some mistakes in talking about this and one press report stated that Einhorn made this claim “without elaborating”. I think he made it very clear how the value would be realized.
So let’s just look at this for a second before I go on.
Here are just some basic figures I pulled off the internet:
AAPL shares outstanding: 940 million
Analyst EPS estimates:
Year-ending September 2013: $45/share
Year-ending September 2014: $50/share
AAPL valuation: 10x P/E
Yield on preferred: 4%
Before Preferred Distribution:
Cash per share: $145/share
Value per AAPL share: $595/share (10x p/e + cash per share).
After $50 billion Preferred Distribution:
EPS: $43/share (EPS – ($50 bn x 4% pref dvd/ 940 mn SOS)
Value per AAPL share:
Cash per share: $145/share
AAPL shares: $575/share (EPS of $43 x 10 + cash per share)
Value of preferreds
(per AAPL share): $53/AAPL share ($50 bn / 940 mn SOS)
Total Value: $628/AAPL share
$628 – $595 = $33/share (difference due to rounding).
[ Note after the fact: In response to comments below, I revised the above table to include cash per share in the total valuation of AAPL. The result is the same as before as cash per share doesn’t change pre and post preferred distribution. But by not including it, it looked like it would be even more value accretive if AAPL distributed cash instead of preferreds. Anyway see comments below. ]
This is pretty much the stub stock scenario in Greenblatt’s Genius book. Speaking of which, this is another perfect case of where we can go out and create our own stub, like Greenblatt said we could (and should).
Create Your Own Stub
So the problem with AAPL is basically that it is ridiculously underleveraged. They have so much cash on their balance sheet that it’s a drag on the performance of the whole company. They have $137 billion cash on the balance sheet that comes to $145/share. That’s just nuts.
But Greenblatt reminded us that even if companies don’t do leveraged recapitalizations too much anymore (except private equity owned entities), we can do our own recap and create our own stub.
So here I’ll just take a quick look at creating an AAPL stub, which I thought I’d never do. Who the heck buys LEAPs on volatile tech stocks? Who needs leverage to own a stock that went from $100 to $700 almost overnight?
Anyway, let’s just say we want to lever up 2-1. I’ll just look at the $250 strike January 17, 2015 calls. You can go up or down the strikes according to your taste.
Apple is now trading at $458.60/share and the 250 strike calls is offered at $211.
So buying the $250 strikes at $211 means you are paying a $2.4/share premium (($250 + $211) – $458.60). Plus you don’t get dividends by owning LEAPs, so you lose out on that. Dividends now is an annualized $10.40/share. The $2.40/share premium above is for two years (let’s round this to two years), so that’s a premium of $1.20/share per year. Add that to the $10.40 in dividends you don’t get and that’s an annualized carry cost of $11.60/share.
Since you are ‘borrowing’ $250 over two years, your annualized financing cost is 4.6%/year. But this assumes dividends don’t go up this year and next. This may be unlikely given all the talk of too much cash on AAPL’s balance sheet. If dividends go up 20%, then the carry cost will go up to 5.5% (assuming a one time bump up in dividends of 20% for the two years).
But this ignores the put option value of owning a 250 strike call instead of actually borrowing cash to buy shares. If you bought AAPL on margin and the stock really tanked, you would get margin called. With a call option, you can’t possibly lose anything below $250 as you are only long a call option that becomes worthless (if AAPL goes below $250 and stays there).
A $250 strike January 2015 put option is offered at $8 or so, so to be really accurate, you should deduct $4/year off of the financing cost above. That gets the carry cost (cost of loan) down to 3% (or 4% if dividends are 20% higher).
That’s not bad at all. I know interest rates are zero, but for a small investor to be able to borrow money at 3-4% is not bad at all. I realize there are discount brokers that offer lower margin rates, but still.
All Options Expire Worthless!
I don’t want to push this stuff too much (as I don’t really know who is reading this), but just to show how low risk something like this can be, let’s think about this for a second.
Many people rightly believe that all options expire worthless. Never mind that that’s not really possible, but it’s not a bad way to think so as to stay out of trouble and not buy calls and puts out of an urge to hedge or get some ‘free’ upside on a momo stock.
But a well thought out LEAPs strategy can be very good.
Let’s take a look at this trade, for example.
If you buy a 250 strike AAPL LEAP for $211, you can’t lose your entire investment unless AAPL goes down to $250/share in two years. From what I read, I think that’s a low probability (well, more on what I think of AAPL later).
One thing that kills option investors is the time value decay. You buy at-the-money or out-of-the-money calls to try to capture upside in a big momo stock that you are afraid to own outright. Or you buy at-the-money or out-of-the-money SPY puts because you are terrified at what the fiscal cliff will do to your IRA.
When you buy at-the-money options over the near term, you are not really borrowing money. You are paying more for the volatility; you are paying a premium for the opportunity to buy or walk away depending on what happens to the stock. This optionality is what you are paying for. You can test this easily by calculating the financing cost of a position and compare it to the option premium. For short-dated options, the financing component is tiny compared to the total option premium.
I have no proof, but I think if someone did a study on options and how people lose money in them, I bet that most of the money is lost due to the amount people pay over the instrinsic value of an option (intrinsic value is simply the in-the-money amount of an option). In other words, it’s the time value that kills them.
So using this unproven rule of thumb that I just pulled out of thin air, let’s look at this AAPL LEAP trade again.
The stock is at $458.60/share. The strike price plus option premium on the 250 strike LEAP is $461/share. So you are paying $2.40/share over the stock price. Add the $21/share of dividends you won’t get and you are paying $23.40 over the stock price. So if the stock price does nothing for the next two years, this is what you lose. You lose $23.40/share (or more if dividends go up). That’s just 5% of the notional amount of the trade, or 2.5%/year. That doesn’t sound too traumatic.
If the stock price goes up or down, you make the same amount as if you were holding the stock, pretty much on a dollar for dollar basis (at expiration, of course. Until then, your option will go up and down according to the delta of the option). And then under $250, you don’t lose any more.
My point is that on a time value basis, you are paying very little premium so you don’t lose a lot of money here if the stock goes nowhere. Compare that, for example, to owning an at-the-money call option which, by the way, is offered at $69 now for the same maturity (2 years). That means you lose 20% of the notional amount of the trade with the stock flat over two years (including dividends you don’t get).
So I would tend to look at these in-the-money LEAP trades (and even shorter maturity options) differently than ‘typical’ option trades; they act more like financing trades. Of course it’s still risky as you are levering up.
What I Still Think of Apple
Not that I have much to add to the Apple debate going on all over the place, I still view Apple the same way as when I made my previous posts about it last year. (Why I Left Apple and Apple is No Polaroid)
I still think Apple was a Steve Jobs story and not an Apple Inc. story. I still think the market breathed a huge sigh of relief after Jobs passed away as Apple continued to perform in the following year. That’s what took the stock up to $700. I keep reading about how “Apple did this. Apple did that. Dell couldn’t do that. Microsoft didn’t do that”. And I always think, no, Steve Jobs did this. Steve Jobs did that.
I still think that the cell phone market will get more and more competitive and mobile companies will get more and more resentful about the huge subsidies they pay for subscribers to get iPhones. When price competition heats up in mobile markets around the world, more and more operators will opt not to pay $500-600 subsidies. I understand that early on it was the other way around. Mobile operators needed the iPhone to attract subscribers.
Over time, I think the “amazingness” of Apple products will become increasingly commoditized. Sure, Apple may still be able to maintain a premium brand status just as they held on to that over time with the Mac, but that may not be enough to maintain or increase the value of Apple as a company.
I do think that Apple is only cheap if one assumes that Apple will come out with something just as mind-blowing as the iPod was, then the iPhone and then the iPad. If all we have going forward are upgrades to iPhones and iPads and competitors continue to close the gap, then I tend to believe that Apple is probably not a cheap stock.
Anyway, I know many people disagree with this view (and many agree), and the hard thing about this discussion is that there really is nothing I can point to to prove it one way or the other. There are plenty of people who know way more about Apple than I do so don’t mind my opinion too much.
Advantage for the Little Guys
But having said all of that, this Apple LEAP trade does look interesting. This is one of the advantages of being small investors. Someone like Einhorn probably couldn’t put this trade on. He has no choice but to activist management into action.
But little guys like us can just say, hey, if you don’t want to lever up, I’ll just do it myself, thank you very much.