Would David Einhorn’s Apple Preferred Stock Idea Really Create Shareholder Value?

This week hedge fund manager David Einhorn, whose investment management firm owns more than 1 million shares of Apple (AAPL) stock, publicly urged the company to take more meaningful action on its ever-rising cash hoard of $137 billion. Since management is not really taking the matter very seriously, despite the fact that every dime of that $137 billion belongs to the shareholders, Einhorn has proposed an alternative idea to unlock shareholder value; issuing preferred stock to existing shareholders, at no charge, with a 4% perpetual dividend.

His thinking revolves around the idea that Apple shares are not adequately valuing the cash on the company’s balance sheet, and issuing preferred stock would actually boost shareholder value because the new stock would have a quoted value in the market that investors could actually monetize if they chose to do so. Einhorn is saying that if implemented, Apple shares post-preferred issuance would be worth more than they are today (because he does not think Apple common stock would fall by $100, the value of the preferred given out). In addition, the 4% dividend on the preferred stock would increase the company’s dividend obligation by less than $4 billion per year, which would easily be covered by future free cash flow and not eat into the current $137 billion cash balance.

So does this plan have merit? I think it does, but I would agree with many who say that it is an overly complicated solution to a relatively simple problem. That said, if Apple is unwilling to take more traditional steps for the benefits of shareholders (after all, Tim Cook and his team work for us), then an idea like this is worth considering (to be fair, since a large portion of Apple’s cash is overseas, repatriation tax issues complicate their possible strategies quite a bit).

Interestingly, today I read a post by Aswath Damodaran, a well known finance professor at NYU, who argues that Einhorn’s idea would generate no shareholder value whatsoever. How he can make such a bold claim, to me, is quite odd. It is true that the idea right now is all theoretical, and there is not a way to know for sure how much the market would value Apple’s common and preferred shares if such an issuance was implemented, but Damodaran equivocally states that value can not be created out of thin air. Here is his exact quote:

“You cannot create value out of nothing and giving preferred stock to your common stockholders is a nothing act, as far as the value of the company is concerned.”

This concept is along the lines of something you are likely to find in a finance textbook. Damodaran would likely argue that a company is worth X, based on the discounted value of future expected cash flows, plan and simple, and slicing and dicing paper does nothing to change that.

I would respectively disagree for a fairly simple reason. I believe that something is worth what someone else is willing to pay. You have probably heard people say that a lot in a wide variety of contexts. For instance, if you are selling your house, just because it is appraised for “X” does not mean that is what it is “worth.” It is only worth the amount that a buyer is willing to pay you for it. Which is why real estate agents value their clients’ homes using “comps,” which are actual sale prices for comparable homes. Original asking prices, or appraised values, are not considered because they are not “real” prices.

The same is true of stocks. At any given time a share of stock is worth the market price, plain and simple. If Apple stock is trading at $470, as it is today, that is what you can sell it for. As a shareholder, that price represents its value to you. At that moment  you can either choose to own one share of Apple or $470 in cash. No other option exists.

Now, an analyst, or portfolio manager, or finance professor can do some number-crunching and conclude that they believe Apple should be worth more than $470 per share (in fact, both Professor Damodaran and I agree that Apple is a bargain currently), but just because someone believes that to be the case does not make it true. In order for our opinions to be proved right, the market has to price the stock at that level. That is the only way we could ever actually sell our stock for a higher price.

Investing in a stock is making a bet that its market value will be higher in the future, affording us the opportunity to sell our shares and make a profit. Professor Damodaran makes the philosophical argument that price and value are not the same, but I respectfully disagree. A share of stock is only worth what someone else is willing to pay and the price someone is willing to pay is the current market price.

So, back to the case of Apple. If the company took David Einhorn’s advice and gave investors $100 of preferred stock for free, for every share of Apple they owned, it is entirely possible that Apple common stock would trade above $370 (the current price less $100). We cannot prove that unless it actually happened, but it is a reasonable conclusion to draw based on Apple’s earnings power ($40 per common share in trailing EPS post-preferred issuance).

In fact, if Apple common shares fetched a 10 P/E, as Einhorn projects, the stock would be $400 and shareholders would then own $500 worth of Apple securities ($400 common plus $100 preferred). Considering that they can now only get $470 for their shares, there would indeed be $30 per share of “value creation” for shareholders. Again, Apple stock is only worth what someone is willing to pay. That amount is the current price. no more and no less. For anyone to argue that no value would have been created for investors in that scenario seems illogical. Price and value are one and the same because there is no guarantee that anyone will ever be willing to pay you what you perceive the value of something to be (how frequently that occurs will determine how good of an investor you are).

I remember reading about a line delivered by Donald Trump in 2007 when asked about his net worth. Here is the exchange:

Trump: My net worth fluctuates, and it goes up and down with the markets and with attitudes and with feelings, even my own feelings, but I try.

Ceresney: Let me just understand that a little. You said your net worth goes up and down based upon your own feelings?

Trump: Yes, even my own feelings, as to where the world is, where the world is going, and that can change rapidly from day to day …

Ceresney: When you publicly state a net worth number, what do you base that number on?

Trump: I would say it’s my general attitude at the time that the question may be asked. And as I say, it varies.

In this case Trump is using the same definition of value that Professor Damodaran seems to be using. Trump says his net worth is X. That is the perceived value, which is why he thinks it can be different based on how he “feels.” Of course, we know that net worth is a technical term. There is no perception involved. His net worth is the amount of money that would be left over if he were to sell all of his assets and repays all his debts. Plain and simple.

As for Apple, I am hopeful that Einhorn’s public challenge of Apple’s capital allocation policies kick-starts some changes at the company. There is no doubt in my mind, and many are in agreement, that the current market price of Apple is largely discounting the value of its massive $137 billion cash hoard. There is no other explanation as to why the stock current trades at a trailing P/E of only 7, especially when you compare it with other technology stocks.

Full Disclosure: Long shares of Apple at the time of writing, but positions may change at any time

The Most Entertaining CNBC Segment Ever: Ackman vs Icahn

Yeah, I don’t think they like each other. It’s rare that two hedge fund titans are on the opposite side of such a controversial trade (Herbalife HLF) and in this case the result is an on-air feud. If you have any interest or follow Ackman, Icahn, Herbalife, and/or activist hedge funds, you might find this as entertaining as I, and many others in the industry, did on Friday when this altercation unfolded live on CNBC.


CNBC: Ackman vs Icahn 01/25/13 (27 min 39 sec)

Chipotle: A Lesson in High P/E Investing

Shares of Chipotle Mexican Grill (CMG) are falling more than 90 dollars today after reporting second quarter earnings last night. Revenue rose 21%, with earnings soaring 61%, beating estimates of $2.30 per share by an impressive 26 cents. However, light sales figures (same store sales of 8% versus expectations of double digits) are causing a huge sell-off today. This is a perfect example of what can go wrong when investors rush into stocks that are very expensive relative to their overall profitability. Any hiccup results in a violent decline. And this really isn’t a hiccup except relative to lofty expectations. If you simply read the press release and ignored the analyst estimates, you would conclude the company is absolutely printing money at its restaurants. Unit-level margins approaching 30% are pretty much unheard of in the industry.

The problem is that prior to today’s drop, CMG stock traded for a stunning 59 times trailing earnings. Even using this year’s projections gets you to a P/E of 45x, more than 3x the S&P 500 multiple. Even a meaningful earnings beat can’t help investors with the bar set so high. Today could very well be a buying opportunity if one believes in the long term growth story at CMG, however, with the P/E still sitting around 34 on 2012 earnings, it is definitely not cheap enough for value investors to get interested.


Full Disclosure: No position in CMG at the time of writing, but positions may change at any time

JPMorgan Sell-Off Excellent Example of Contrarian Opportunity

News of a $2 billion trading loss at JPMorgan Chase (JPM) last week prompted a 15% sell-off in the stock, which now sits more than 20% below its 52-week high, at a trailing P/E ratio of 8, at only a slight premium to tangible book value, and with a dividend yield above 3%. One of the best ways to be a successful investor is to buy quality companies at times when their share prices are temporarily depressed due to short term news headlines that likely will not impact the long term profit generation of the company. Warren Buffett has perfected this investment strategy over many decades. While JPM was not really on my radar before last week, the recent events at the company have changed that. At around $36 per share I think JPM makes for a very attractive long term investment. As a result, I have initiated a position in the company.

Full Disclosure: Long shares of JPM at the time of writing, but positions may change at any time

Biglari Succinctly Criticizes Cracker Barrel’s Strategic Plan in Pursuit of Board Seat

As an investor looking for attractive places to allocate your capital, one of the biggest things you can try to avoid are companies where the management team takes actions that do little to maximize shareholder value. Oftentimes these same managers have very little “skin the the game” (stock ownership in their own company), giving them little reason to care about the stock price.

The operating performance of restaurant chain Cracker Barrel (CBRL) over the last decade or so has been dismal, which has led Sardar Biglari, CEO of Biglari Holdings (BH) to amass a 10% stake in the company and seek a board seat at next month’s annual meeting. This week Biglari wrote a letter to CBRL shareholders explaining why he wants on the board and what his ideas are for value creation. The letter is very well written and highlights issues that are all too common with public companies. Time and time again decisions seem to be made without much financial analysis. The end result is wasted shareholder capital and value destruction for equity holders.

You can read the entire letter to CBRL shareholders here, but I think it is important to cherry pick a few of Biglari’s points, as they apply to many companies, not just CBRL. Below are some direct quotes from the letter (in italics), followed by some of my thoughts.

“Cracker Barrel’s performance during Founder Danny Evins’ era was stellar. However, since Michael Woodhouse became Chairman and CEO, the underlying store-level operating performance has been deteriorating. Instead of restoring the formerly successful store-level performance, Mr. Woodhouse has spent over $600 million in capital over the past seven years while over the same time span operating profit declined.”

Biglari provides the hard data that shows 2005 revenues of $2.2 billion and operating income of $169 million, versus 2011 revenues of $2.4 billion and opearting income of $167 million. Indeed, the current management team has spent $615 million on capital expenditures since 2005, which has grown revenue by 10% (entirely from new store openings) but failed to add a single dollar of profit to the company. Biglari uses this data to argue the company should not be wasting money on building new stores today (the company’s current plan is to spend $50 million on them in 2012). All too often management thinks the best thing to do is to get bigger, even when doing so adds nothing to the bottom line.

“After all, it is easy to spend money to open new units. The trick and triumph are to achieve unit profit both sufficient and sustainable without a diminution of performance in existing stores. The principal reason unit-level performance has been dismal is that unit-level customer traffic has been declining. On this important measure, customer traffic has been consistently negative in each of the past seven years. There are currently about 960 customers, on average, that go through each unit per day, nearly 190 fewer than seven years ago.”

Again, Biglari provides traffic data that shows a 15% decline in customer traffic per existing unit since 2005. This is yet more evidence that opening new stores is a waste of money and is destroying shareholder value. It is clear that even ignoring new store cannibalization (which certainly exists at least to some minor extent), traffic at existing stores is falling. Why then open new stores?

“Mr. Woodhouse in essence has produced the same level of profit with 603 stores that Mr. Evins did with 357 stores. If Mr. Woodhouse could have simply returned the Company to the productive level achieved in fiscal 1998, there would be an additional $110 million in operating profit, and we estimate $1 billion added in market value or the doubling of the current stock price.”

Biglari shows operating profit per store of $462,000 in 1998 (357 stores), $319,000 in 2005 (529 stores), and $277,000 in 2011 (603 stores). He concludes that new store expansion should be halted and management should work on getting the existing store base back to the level of profitability that existed more than a decade ago. It seems so simple, but management is clearly clueless, which is why Biglari is seeking a board seat as the company’s largest shareholder.

“When determining where to direct capital, management should evlaute all options and then place capital based on the highest return after compensating for relevant risks. The math is simple: The cost of a new unit including land, building, and pre-opening expenses is between $3.5 million to $4.7 million. Cracker Barrel’s current market value is about $1 billion. With 608 units, the market value per store is $1.6 million.”

This is something that I see all the time with public companies that require large upfront investments to expand their unit base (restaurants, hotels, casinos, etc). It drives me crazy. In the case of CBRL the market is valuing each store at $1.6 million but management is choosing to spend tens of millions per year on new units at a cost of no less than $3.5 million each. Opening a new unit results in an immediate loss of $1.9 million for shareholders, or 54% of the investment! No wonder the stock has been in the tank. Conversely, if the company uses their capital to repurchase stock (essentially buying back their own stores at $1.6 million each), and then improves the profitability of those stores, the stock price will go the other way. Investors should always be wary of companies that spend “X” to build a new unit when the market is valuing their company at less than “X” per unit. Getting bigger for bigger’s sake without looking at the returns on invested capital is a sure-fire way to destroy shareholder value.

So why on earth does the CBRL management team seem to not care about deteriorating store-level operating performance or their poor returns from new store expansion? Well, in addition to the fact that management hardly owns any stock, Biglari points to their compensation system as a culprit:

“We believe in excellent pay for performance. But the Board has designed a flawed compensation system, one with a low bar for achievement. For 2011, executive officers were eligible to receive a bonus of up to 200% of target (target being median reflected by our peer group) if operating income met or exceeded $90 million. To put in context the absurdity of the $90 million bonus target, Cracker Barrel has not had operating income below $90 million in any year since 1994! Why would a Board set eligibility at a level unseen in nearly 20 years?”

Of course, the answer is it ensures they can collect maximum bonuses without showing any job competence. In this case operating income can decline by nearly 50% and they still collect a 200% bonus. It is not surprising then, that CBRL’s operating income has actually declined over the last seven years, despite new store growth. Management has no incentive to reverse that trend because they only own a little bit of stock in the company and they get their bonus regardless of what happens.

It’s not hard to see why Biglari Holdings has taken a 10% stake in CBRL and Mr. Biglari is trying to get on the board of directors. If he is successful, there is no doubt that taking even some of his advice would get the stock moving again, as corporate financial results would have no where to go but up. Also not surprising is the effort CBRL management is putting forth to defeat his election (if only they put that much time into improving the company!). To give you an idea of how much they value their shareholders, Biglari ends his letter with this final observation:

“I hope to see you at the annual meeting, a gathering for shareholders to learn more about the Company. Annual meetings represent another window into the culture of the organization shaped by top leadership. Unfortunately, even on this mark, the Board sends the wrong message: Cracker Barrel has chosen to hold its upcoming annual meeting during Christmas week on December 20, 2011. While we will attend the meeting regardless of date or time, it is not the way shareholders should be treated. It is time to change the ethos of the Company to one that cares about shareholders and respects their money and their time.”

Now, as a shareholder of Biglari Holdings this letter and proxy fight is a material development in which I have a keen interest. However, even if you are not in the same boat, I think it highlights important lessons for all investors who are trying to identify superior investment opportunities. Beware of companies like CBRL whose management teams seem to make one mistake after another. They usually claim to want to maximize shareholder value, but oftentimes take actions that ensure the opposite. Be especially wary of companies that have a desire to expand their unit base, at a huge cost, even when the public markets will ensure such capital investments never return a profit to shareholders.

Full Disclosure: Long shares of Biglari Holdings at the time of writing, but positions may change at any time

Reader Mailbag: Is Salesforce.com (CRM) a Good Short Candidate?

Tim writes:

“Hi Chad, you’ve probably looked at CRM as a “short,” any chance we’ll see a blog update with your thoughts on this one?”

Thanks for the question, Tim. I have several thoughts that pertain to Salesforce.com and other high-flying, excessively priced growth stocks in general.

Shorting these kinds of stocks is very dangerous. As a value investor, I certainly believe that excessive valuation is a huge red flag for any stock, but the key question is whether or not that sole factor alone is enough reason to bet on the price declining meaningfully, as opposed to simply avoiding it completely on either side. Unless there is a clearly identifiable deterioration in the company’s fundamentals, I tend to avoid shorting stocks merely because they are extremely overvalued.

The problem is that the market tends to give high growth companies elevated valuations as long as they keep delivering results. As a result, the short trade can go against you for a while, making it such that you must time the trade very well, and market timing is tricky. It is quite possible you will lose money for a while, and even if you are eventually right about a price decline, most of your gains by that point might only really recoup the losses you sustained initially. Without a negative catalyst (a breakdown in the operating business) it is very hard to time valuation-based short trades well enough to make good money consistently.

Now, in the case of Salesforce.com (CRM), the stock trades at about 90 times 2011 earnings estimates. Even for a company that is well positioned to grow for many years to come, one could easily argue that even at an elevated price of 40 or 50 times earnings, there is plenty of room for downside here. And I would not disagree with that. It really is just a matter of whether you want to explicitly bet on a huge decline, because you not only need to be right about the price, but you need such a decline to begin relatively soon after you short the stock, because momentum names like CRM can keep rising for longer than most people think.

Unless the market in general has another huge meltdown, these situations typically result in the stocks moving sideways for a long time, in order to grow into the hefty valuation Wall Street has assigned to them, assuming that their business fundamentals are not deteriorating. While I do not follow CRM as closely as many others do, I am unaware of any reason to think their business is set to take a dive. If that thesis is correct and the company continues to grow nicely, I would feel more confident betting on the stock moving sideways even as rapid growth in their software business continues.

To illustrate this idea, let’s consider past examples of stocks that were excessively priced, but still burned the shorts since the business fundamentals remained strong. Amazon.com (AMZN) is a prime example of a stock that many people have tried (unsuccessfully in most cases) to short in recent years. Amazon has continued to post phenomenal growth as it takes market share in most every category it expands into. In fact, just over the last few years many investors have argued it was a prime short candidate (and still do, at the current price of 52 times 2011 earnings estimates). As their business has continued to grow, Amazon shares have actually risen from around $70 two years ago to $165 per share today. Shorts over this period have gotten crushed.

If we go back in time, however, we can see that Amazon shares really have underperformed (relative to their underlying business fundamentals, anyway) for a long period of time. The stock peaked in December 1999 at $113 per share, when Amazon’s annual revenue was a mere $1.6 billion. Today, more than 11 years later, Amazon’s sales are on track for $45 billion annually, but the stock is only about 50% above 1999 levels. This is entirely due to the fact that the valuation in 1999 was so high that it already factored in years and years of stellar growth. Sales at Amazon have grown 28-fold (2,700%) since 1999, but the stock is up only 50% during that time. Believe it or not, that makes the investment a disappointment for those who had the foresight to predict Amazon’s explosive growth potential a decade ago. The valuation simply mattered more because it was already factoring in tremendous growth opportunities. Perhaps the same situation may be brewing with Salesforce.com.

As a result, I would personally prefer to avoid CRM rather than short it today. In more cases than not, shorting a stock based on valuation alone can get dicey pretty quickly, whereas finding a company with deteriorating fundamentals AND a high valuation has a much better risk-reward profile. Think Crocs, circa 2008, as one example.

Large Brokerage Firm Recommendations Performing Poorly, Again

Another piece of data supporting the idea of contrarian investing, this time from Bloomberg.

The money quote:

“Companies in the Standard & Poor’s 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest “buy” recommendations gained 165 percent, according to data compiled by Bloomberg. Now, bank favorites include retailers and restaurant chains, the industry that did best in last year’s rally and that are more expensive than the S&P 500 compared with their estimated 2011 profits.”

Earnings Growth Does Not Predict Stock Market Returns

Lots of readers are writing in to question my assertion that the stock market does not track corporate profits or GDP. They seem upset to learn that if you can correctly predict GDP growth or earnings growth in the short term that you can’t also predict the direction and magnitude of the market’s moves. The key here is that the market prices in certain expectations about the future ahead of time and then readjusts prices based on how the future plays out relative to those expectations. We cannot simply infer that, say, over the next year GDP will grow 3%, leading to earnings growth of 8%, and therefore the market will rise 8%. Markets are more complicated than that!

Here is an illustration I came up with to back up these claims (raw data compiled by NYU from Standard and Poor’s and Bloomberg). As you can see, correctly predicting S&P 500 earnings growth (grouped along the x-axis) for any given year does not help predict the market’s return (plotted along the y-axis) during that same year. In fact, the market does better when earnings are declining, relative to how it fares when earnings are growing by double digits. In the near future I will try and compile data that shows which figures actually have predictive value.

Record Corporate Earnings Continue to Fuel Stocks, Analysts Optimistic for 2011

According to financial data collected by Thomson Reuters, 70% of S&P 500 index companies have reported third quarter profits so far and earnings are up 30% year-over-year. This compares to estimates of just 24% growth and explains why the U.S. equity market is knocking on the door of the 2010 highs made back in April. For all of the pundits complaining that Washington DC politicians have been bashing Corporate America too much, aggregate corporate profits are actually making new record highs (second quarter earnings were an all-time record) so we have to wonder exactly how tough companies really have it these days.

As we head into 2011 analysts are expecting corporate profits to keep surging, by about 13% next year. With P/E multiples about average historically, the strength of earnings will likely dictate much of market’s movement in 2011. Analysts notoriously overestimate profit growth (by a factor of nearly 2x over the long term according to studies done by McKinsey), so once again they are very optimistic about the coming year (corporate profits grow about 6% per year over long periods of time). As is usually the case, the numbers are telling a better story of reality than political and private sector commentators, which is why the market is doing pretty well despite 9.6% unemployment.

To gauge market prospects for next year, investors should continue to look at the numbers and ignore the posturing in the media and on the campaign trail. As things stand now, I would expect another gain for the U.S. equity market in 2011, but the magnitude will depend on whether the analysts are right or once again overly optimistic. That could be the difference between single digit and double digit returns over the next 12-15 months for stocks.

And on a somewhat related note, don’t forget to get out and vote tomorrow.