Over at Moneybox, Matt Yglesias has a nice summary of and commentary on hedge-fund investor David Einhorn’s attempts to get Apple to raise its stock price by making a credible promise to pay out larger dividends to its shareholders — and Apple’s subsequent refusal.
Basically, as we all know, Apple is one of the most profitable and seemingly promising companies in the world. But its price-to-earnings ratio (i.e., the price of the company as a whole [every one of its shares summed] divided by its yearly earnings) is low — about 10, compared to about 17 for the market as a whole. That is, investors are valuing ownership of the company at only ten times its yearly income, while valuing most companies at around 17 times their yearly income. Why is this? Well, it could be that investors are pessimistic about Apple’s future, thinking that its current high profit margins and market shares will be unsustainable as, e.g., the smartphone and tablet markets continue to get more competitive and mature. But another component of this is probably that investors are frustrated with Apple management’s refusal to return much of its profits back to the company’s owners in dividends and share repurchases. That is, Apple may have a high value, but that value isn’t getting returned to investors fast enough, and so investors are discounting the company. Apple has, instead of returning its enormous profits to investors as dividends, accumulated massive stockpiles of cash. As Yglesias notes, “Apple’s cash on hand represents over a third of its market capitalization, giving them a high cash-to-stock value ratio.”
Why has Apple done this? The main reason we see cited is that the tech world can be pretty volatile and Apple has gone through some very tough times in the past — so the company is holding on to this cash as a “war chest” in case it gets threatened by aggressing companies in the future. The cash could come in handy if Apple needs to beat back some competitor by selling products at a loss. Or if in 5 years, say, interest rates rise and some new technological space opens up, the cash will come in handy if Apple wants to make a huge investment in the new technology, without incurring new interest expenses by borrowing from banks to finance the investment. So it’s understandable that Apple’s management would accumulate cash. But it’s also very frustrating to Apple’s shareholders whose shares would, if the company were trading at the market-average P/E ratio, increase by 70%. (Keep in mind also that, given Apple’s huge market capitalization, its investors probably include you and me, if we’re invested in any sort of fund that tracks the market.) And it’s equally frustrating to those of us who take seriously the moral idea that managers should serve as agents as shareholders, and should return cash that the company does not have immediate use for — rather than withholding it and saying to the markets, as it were, ‘we know better than you what to do with this extra cash.’
Enter the charismatic David Einhorn, the activist investor at the head of Greenlight Capital. His hedge fund owns .12% of Apple, amounting to some $530 million worth of shares (meaning there is $370 million in it for his fund if Apple can start trading at a normal P/E). He’s been going on TV shows, and to Apple itself, with an idea that, he claims, can allow Apple to hold on to its “war chest” in the short-term, while credibly committing (read: legally binding) the company to return cash to shareholders over the long term. Basically, Einhorn wants Apple to issue a large “preferred stock dividend.” Preferred stock is stock that gives the company a legal obligation to pay a certain pre-defined dividend in perpetuity, if the company pays any dividends at all (this is why preferred stock is sometimes conceptualized as a “hybrid” between equity and debt). As a “stock dividend,” these proposed new preferred shares would be issued to existing shareholders (i.e., a “50% preferred stock dividend” would mean that a shareholder who had 2 shares of Apple common stock would additionally be granted 1 share of the new preferred stock). So Einhorn’s idea is that, by doing this, Apple would preserve its cash “war chest” right now while giving each shareholder a legally enforceable commitment to a larger dividend on her preferred shares — this should immediately increase the value of Apple shares, by beating back the skeptics who fear that Apple will never pay out. In Einhorn’s terminology, this would “unlock value” for shareholders, while still allowing Apple to preserve its conservative investment strategy.
Right now, as I understand it, this is all in a sort of confusing legal limbo — Apple made some changes to its corporate charter that, Einhorn claims, were intended to thwart this plan, so Einhorn threatened to sue to stop it; Apple claimed that Einhorn misunderstood what they were doing, and is seriously considering ways to return value to shareholders. It will, no doubt, continue to unfold. But I want to step back and consider this from a broader perspective. What should we want Apple to do? What is the “socially optimal” path? Yglesias writes:
Beyond the investment strategy debate, there’s a great issue here as to whether the “disgorge the cash” mentality that Einhorn reflects is socially optimal. In many cases I would argue that no, it isn’t. Microsoft’s shareholders would probably be better off if, years ago, the company had simply decided to ride out Windows/Office for as long as possible and kick the profits back as dividends. But the social returns to Redmond’s decision to not go gentle into that good night have been large. Microsoft hasn’t made any money creating Bing, but it has done consumers all around the world a huge favor in keeping Google honest. And Google’s fear that Windows Mobile would somehow lock it out of the mobile search marketplace was the initial impetus for the Android project. Android, too, doesn’t necessarily look like a great dollars-and-cents investment for Google, but it’s been fantastic for the broader world. Back in the day, we got R&D divisions like Xerox PARC and Bell Labs out of a similar “waste” of shareholder value.
So from my view, the problem with Apple’s cash is the reverse of Einhorn’s. They’re not wasting it aggressively enough. The company’s fastidious approach means they’re not going to blow $40 billion on trying and possibly failing to bring an autonomous car to market. They’re not investing in the creation of original programming the way Netflix is. They’re not running near-zero profit margins like Amazon. They’re just making lots of money, perhaps because Tim Cook watched The Corporation or read an Introduction to Microeconomics textbook and got it into his head that maximizing profits is what companies do. Which is kind of sad. They’re obviously really smart people and I bet they could make some cool stuff—and even come up with some plausible-sounding reasons for doing it—if they would just relax a bit.
In other words, Yglesias is pointing out that companies that reject a “narrow” focus on shareholder value give themselves the freedom to take on risky, innovative, not-clearly-profitable projects that can benefit society as a whole — like Microsoft giving Google some competition or Google pioneering driverless cars. Apple could, ideally, hold on to its cash and make some incredible investments in some other futuristic technology — say, something that would allow driverless cars to communicate with each other, so that cities can perfectly optimize traffic flows, etc. Now, I take very seriously what Yglesias is saying here — my long-time readers know just how very excited I am about the prospects of integrated driverless cars, an enterprise which is uncertain to do much for Google’s shareholders, but will do a lot for the world. But I want to push back with a couple of arguments, and then open this for debate.
-First, it’s a false dichotomy to say that companies must either “invest in our shared future” or “keep a narrow focus on shareholder value.” Rather, when a company returns cash to its shareholders, it’s putting money in their hands and allowing them to decide what to do with it. They can — and often do — decide to invest that money in some new, alternative startup that will also do a lot for our shared future. Would it be cool if Apple was doing some side-projects to integrate driverless cars with urban grids? Yes. It’d also be cool if I could cash out of my investment in Apple at a higher price, and invest that extra money in some other, outside startup that was doing the same thing. So you can’t just argue that a company should hold onto cash because “investing in our shared future is good” — rather, you have to argue that the company is better at investing in our shared future than are the capital markets. And if you endorse this position, this means you’re privileging the expertise of a small management team over the distributed knowledge of the market as a whole. That’s not a ridiculous idea — but it is, at least, a debatable one.
-Second, I think it’s important to step back and consider not just this particular company but the ecosystem of capital markets as a whole. When Apple went public in 1980, it was able to raise a lot of cash from the public because its investors took seriously the idea that Apple would do its best to give them a good return on their investment. And that IPO, by providing cash to a company that would use it to advance technology that would benefit the world in so many ways, was a great thing for the world. But if many more companies go down Apple’s subsequent alleged path — of failing to do its best to maximize shareholder value — investors may start to discount the price they’ll pay for shares in new companies. That will mean that less capital will make it to promising upstart companies, which would be bad for the world in the aggregate. In other words, the socially-efficient allocation of investment to startup companies in IPOs depends on a business culture in which management teams take seriously their role as “agents” of their investors. So even if in this particular case, Apple could do more good for the world by holding onto its cash, it might contribute to pessimism among investors, in ways that raise the cost of capital for future companies, hurting society in the long run.
Quick note. The Business Babe, who is generally more practical-minded than I am, just peeked over my shoulder and argued as follows: “Basically, a company should start paying a dividend once its market has matured, when it knows what its cash flow will be like, and won’t need to hold onto cash for new or unpredictable R&D investments. But once its past that stage, a company can’t hold onto investors with promises for the future — it needs to give them a steady return on their investment right now. And tech right now is sort of like the adolescent that refuses to leave home — not moving on to the next stage. The tech boom is over, and tech companies no longer need reserves they used to. And so to continue to hold on to their cash reserves is to be denial of what has happened. Tech companies have to recognize that the tech boom of the ’90s is over. Tech is a mature industry, and tech companies need to start acting like mature companies.”
So those are just a couple things to consider. Should Apple disgorge its cash reserves? What do you think?
–Matt, blogging boldly from snowed-in Boston