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February 7, 2013, 1:25 PM.

What’s Einhorn Thinking? Finance Professor Explains.

By Steven Russolillo

David Einhorn’s fight with Apple Inc. has reignited the age-old question: What should Apple do with its boatloads of cash.

Einhorn touted the benefits for Apple issuing preferred shares to create more shareholder value.

“We think for every $50 billion of preferred that they issue it will unlock about $32 a share in Apple,” Einhorn said on CNBC. “If Apple used about half of their earnings towards this program, we think they would be able to issue approximately $500 billion which would unlock about $320 a share.”

Preferred shares are often viewed as high-yielding hybrids that are less volatile than common shares and typically pay generous income stream akin to high-yield bonds.

With some $137 billion in cash on Apple’s balance sheet — bigger than the market caps of all but 17 companies in the S&P 500 — many investors and analysts have been calling for Apple find more ways to deploy addititional cash to shareholders. The company started paying a regular dividend last year and announced a stock buyback.

MarketBeat chatted with James Angel, associate professor at Georgetown University, who offered his take on Einhorn’s latest move and the best ways for Apple to use its cash.

MarketBeat: What’s Einhorn’s motive?

Angel: “He wants Apple to leverage up by using preferred stock. What it effectively does is it leverages up Apple’s capital structure. Normally when a company does that, they do it with debt, but Apple has been pathologically averse to adding debt. Since Einhorn feels the stock is undervalued, by adding leverage, it should provide a kick to the stock price.”

MarketBeat: Why preferred shares as opposed to boosting the dividend or stock buyback?

Angel: “One problem with a big buyback or dividend is that so much of their cash is sequestered as “overseas” for tax purposes.  They would take a big tax hit if they repatriated the cash right away to do a dividend or buyback…

“Clearly, cash is negative debt. If Einhorn wants to leverage up the company quickly, he can have them buyback shares or pay bigger dividends. But the nice thing is if they just spinoff these shares, which effectively are going to become like a bond, the tax treatment on this would be longterm capital gains. The tax treatment if he sold shares back in a buyback would also be a longterm capital gain, but he may be planning for tax purposes to hold on to this for a bit longer. If he receives a big dividend, yes it’s at the preferential tax rates for dividends, but if he engineers a longer-term boost in the price of Apple, what that would do is allow him to defer the payment of the capital gains tax until he finally sells it down the road, or spins it off to his investors who can do whatever they want. It may be a sophisticated tax angle that’s calling the push for preferred shares as opposed to a cash dividend or buyback…

“I think that Mr. Einhorn should have also asked for a 10:1 stock split for Apple, which would increase its liquidity a tiny bit and probably boost its price a smidge.”

MarketBeat: Why would Apple want to eliminate the ability to issue preferred stock?

Angel: “Apple wanting to give up its flexibility is curious. I suspect they want the activist investor to go away. Since Einhorn, the activist, is saying he wants to get shareholders on board to vote on it, maybe Apple is hoping he’ll go away and bother some other company. But let’s say Apple is successful and the preferred option is taken away. In that scenario the risk is Mr. Einhorn and his peers have big chunks of stock. They could come up with other ideas. I don’t think Einhorn has the desire to take over Apple, but he may very well do something else if he loses this proxy vote.”

MarketBeat: What if Einhorn’s not successful?

Angel: “He may want to wage a direct proxy fight and say hey, I’ve been a shareholder for several years. Now I’d like to be on the board. I’m not sure why Apple would want to take away their flexibility to do this. Even if Apple wins, the activists may come back with something which would be more sour to the Apple core. ”

MarketBeat: Why would Calpers side with Apple?

Angel: “That’s a good question, especially since Calpers has historically been a fairly active investor. Apple is a California-based company so I wonder if there are any political considerations going on there. One of the dangers with big pension funds is there may be political considerations of what they do. My guess is that Calpers is either 1) so happy with eliminating the staggered board that they don’t care about the preferred stock, or 2) they want to show publicly that they are not in cahoots with Mr. Einhorn.”