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Apple Inc
Date: 28 February 2013

The Case Against iPrefs

It is rather hard to see the point in Greenlights iPrefs proposal. At the heart of iPrefs is the exploitation of the difference in capitalisation rate between the fixed income and equity market. This may seem ingenious but the corresponding introduction of interest rate risks and reduction in capital management flexibility are hardly great trade-off. Furthermore, there are a myriad of inputs that affect the return of iPrefs such as current yield, expected spread of iPrefs, P/E of AAPL, AAPL current share price, amount committed to iPrefs, etc. All these create a lot of uncertainties and do not appear to be something the shareholder should trade off just so that AAPL share could go to USD600. Instead of reward, risks take precedence here.

Buy
Fair value Previous FV Share price Yield Capital gain Total return Conviction Stock code Market cap USD600 USD600 USD450 +2% +33% +35% High AAPL US USD476bn

Robin HU
robin@nonameresearch.com

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Greenlight's iPrefs Proposal

Greenlight proposed that Apple (AAPL) issue iPrefs which are perpetual preferred stocks with the following attributes (1) it pays quarterly dividend perpetually (no maturity) (2) AAPL has the option to redeem at face value (3) iPrefs will be listed. Note that (1) and (2) defines the instrument and can exist separately without (3). In other words, you can have unlisted iPrefs but it will be shown later that (3) is a critical component of iPrefs. An example of how Greenlight envisioned iPrefs will work is as follow. Assume that current AAPL share price is USD450 or 10x PE on EPS of USD45. AAPL will distribute one USD50 iPref per common share at 4% annual dividend payable quarterly (or USD2 annually) The shareholder will then sell this in the market (this follows from (3) above) for USD50 Because of iPref payment, EPS declined to USD43 and assuming no changes in PE multiple, AAPL share price reduces to USD430 Add the earlier USD50 proceed from iPrefs sale to USD430 and the shareholder would have a value of USD480 for their share

Furthermore, Greenlight is interested in more than the above. Greenlight prefers that 5 iPrefs be issued per common share. At this higher iPrefs distribution, each shareholder will then sell 5 iPrefs in the market for USD50 each or USD250 in total Again, as before, EPS will decline to USD35 (more this time due to the higher number of iPrefs issues) or share price of USD350 at 10x PE Under this scenario, shareholder would have increased the value of their share USD250+USD350=USD600

Hence, according to Greenlight, distributing iPrefs could "unlock value" by increasing AAPL value to the shareholder to USD480 to USD600 from current price of USD450. Greenlight goes on to say that iPrefs are the best option for AAPL as it allows AAPL to "keep the cash" while "rewarding shareholders in a big way". We seek to show that iPrefs are not a good option for both AAPL and the shareholders by showing that iPrefs surreptitiously introduced interest rate risks to the shareholders reduces AAPL capital management flexibility

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The Sleight of Hand

Exploiting difference in capitalisation rate
Before explaining the potential negative impacts of iPrefs, it is important to get to the heart of what makes iPrefs tick. So what lies behind iPrefs apparently ability to create shareholder value? The short answer is "capitalisation rate". The long answer is "exploiting the difference in capitalisation rate between the equity and the fixed income markets". At present due to the low interest rate environment, cash flow into the fixed income market is capitalised at a high rate. Greenlight has implicitly assumed that the fixed income market will capitalised the dividend/coupon from the iPrefs at 4% yield or 25x "P/E". This is how a USD2 perpetual iPref cash flow stream is expected to be worth USD50 AAPL on the other hand is currently being capitalised at 10x P/E since the market value AAPL at USD450 on EPS of USD45 Hence, there exists a discrepancy in the fixed income market (with 25x P/E) and the market for AAPL stock (with 10x P/E)

This difference in capitalisation rate is precisely what iPrefs exploit to enable it to unlock value.

Carving out and redirecting AAPL cash

Because of the difference in capitalisation rate, it makes sense to direct AAPL cash flow away from the equity market into the fixed income market where it can be capitalised higher. How can this be done? One quick way to do this is to raise debt but AAPL management is debt averse. Another way is to carve out a portion of AAPL cash flow and commit to a periodic payment using an instrument that rests fortunately in the grey area between debt and equity; a preferred share. Doing so allows access to the fixed income market while circumventing the debt stigma. iPrefs dividend/coupon results in a cash flow carve out. At 5 iPrefs, USD9.5bn is carved out from AAPL cash flow indefinitely This is a committed payment and needs to be satisfied ahead of any operational, capex, M&A needs, distribution to shareholders The only way for AAPL to absolve itself from this payment is to redeem the iPrefs (which Greenlight says shareholders "should not expect") Stopping the payment temporarily does not absolve AAPL from the commitment but merely delays it as iPrefs are cumulative

The cash flow carved out needs to be redirected into the fixed income market and this is achieved by listing the iPrefs. This is important for without a market, shareholders could not exit their iPrefs and realise the higher capitalisation of the fixed income market and no value will be "unlocked". So there you have it, iPrefs force a carve out of AAPL cash flow, pump it into the fixed income market, capitalise it at 25x and then cash out. No problem, then? Well, not quite again. There is just that other bit; risk.

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Note: Before turning to iPrefs risk, it is worth mentioning that it can be hard to agree with Greenlight that "iPrefs are equity, not debt" and "[iPrefs] have no maturity and no refinancing risk" . Firstly, if iPrefs are equity, one should expect voting rights, share of residue income, etc instead of being limited to a fixed payment. Also, note that the expected buyers of iPrefs would be institutional fixed income funds, pension funds, insurance funds and endowment funds. All these entities are in the market for fixed income. So if the buyers are buying fixed income instruments, won't this mean that the seller is selling fixed income instruments as well? Even Greenlight itself was comparing iPrefs to Microsoft and IBM long dated debt and 30 year US bonds. Secondly, it is not quite true that there is no maturity on the iPrefs. As mentioned, AAPL can not absolve itself from iPrefs without a redemption. There is a maturity date, it is just not set in stone. Thirdly, it is also incorrect to say that there is no refinancing risk. Far from it, the iPrefs are refinanced at the market yield whenever it is distributed to shareholder.

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iPrefs Silent Risks

iPrefs create exposure to interest rate risk
One of the key downside of iPrefs is that it immediately introduces equity shareholders to interest rate risks. Recall, iPref value is derived by exploiting the difference in capitalisation rate between the fixed income market (where iPrefs are disposed) and the equity market (where AAPL is being listed). Once distributed, iPrefs need to be disposed in a fixed income market in order to cash out. And here lies the risk in iPrefs. The iPrefs value is subservient to market yield. Market yield is not stable and have made big movements in the past. Lets just take for example the US 10 year bond yield. There were three broad movements. Roughly speaking, from 1900 to 1950s where yield declined from 6% to around 2%. Then from 1950s to 1980s, the yield increased from 2% to a high of almost 16%. And from 1980s to today, the yield declined again to sub 2% mark. These swings create interest rate risks and this is alluded to by Greenlight but unfortunately not expanded upon. Lets expand on this and look at a specific example of how rising interest rates will reduce iPref attractiveness by revisiting Greenlight 5 iPrefs proposal. Recall that under this scenario, the 5 iPrefs with par value of USD50 each are expected to be sold at par in the market for a total of USD250. This is the case because the "coupon" on the iPrefs (4%) is the same as market's required yield (assumed by Greenlight to be 4% also). What happens to the iPrefs when the market yield increases from 4% and say to 6%? Well, when the market yield increases to 6%, the iPrefs can no longer be sold at par and must trade at a discount instead. Specifically, each USD50 iPref will can now only be sold for around USD33 each instead of USD50. Five iPrefs will now net the shareholder USD167 instead of the original USD250 Assuming all else is the same as before, the share price will still decline by the same amount to USD350. The value of AAPL share to shareholders will now be USD167 + USD350 = USD517 or 14% less than the original USD600 arrived at by Greenlight. Now USD517 still represents an increase from the assumed USD450 current share price but the purpose here is to illustrate that a rising market yield negatively affect the upside to shareholders In fact, in this particular example, the break-even market yield is 10%. Issuing iPrefs at above 10% will result in a loss to shareholder value iPrefs upside is further reduced at higher starting AAPL share price. Greenlight used USD450 as a starting number but repeating the analysis at higher starting number reduces the upside. In other words, the same iPrefs distribution done at say USD600 will have less upside than distribution done when the share price is USD450

iPrefs actually reduces capital management flexibility

Contrary to Greenlight's view that "the important benefit of iPrefs is that they don't interfere with whatever Apple's business plan is", it appears that iPrefs actually constrict AAPL options. As touched upon earlier, the iPrefs result in a committed payment that needs to be satisfied ahead of any operational, capex, M&A needs, distribution to shareholders and the only way for AAPL to absolve itself from this payment is to redeem the iPrefs (which Greenlight says

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shareholders "should not expect"). Stopping the payment temporarily does not absolve AAPL from the commitment but merely delays it as iPrefs are cumulative. Because AAPL is committed to the iPrefs payment, it will have less FCF (around USD10bn less with 5 iPrefs). This restricts capital management option in a number of ways. Even more cash needs to be hoarded on the balance sheet because AAPL management now knows that is has less FCF to fall back on after iPrefs. There is now a ceiling on dividend to common shareholders because AAPL cash flow needs to be redirected to serve the iPrefs AAPL has less flexibility to pursue opportunistic share buyback in the event of large decline in share price What happens if AAPL P/E expands? If the expansion is large enough, it may now be more desirable to have higher EPS but here iPrefs EPS drag will now be a negative factor

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Conclusion
It is rather hard to see the point in Greenlights iPrefs proposal. At the heart of iPrefs is the exploitation of the difference in capitalisation rate between the fixed income and equity market. This may seem ingenious but the corresponding introduction of interest rate risks and reduction in capital management flexibility are hardly great trade-off. Furthermore, there are a myriad of inputs that affect the return of iPrefs such as current yield, expected spread of iPrefs, P/E of AAPL, AAPL current share price, amount committed to iPrefs, etc. All these create a lot of uncertainties and do not appear to be something the shareholder should trade off just so that AAPL share could go to USD600. Instead of reward, risks take precedence here. However, having said that, Greenlight does have a point about too much cash on Apple balance sheet. Imagine you own a restaurant (perhaps one with aluminum cutlery) and you hired great managers to run it. Business is doing wonderful and cash just keep piling up but at the end of the month, the managers refused to remit the earnings back to you but let it sit in the till instead. Would you not be mad? You would probably tell the managers that unless they clearly explain why they are hoarding cash, they must remit it back to you. Hoarding should be the exception and not the rule. It is your money after all. And that is, unfortunately, something that AAPL management does not seem to understand very well.

nonameresearch.com | 28 February 2013 Rating structure The rating structure consists of two main elements; fair value and conviction rating. The fair value reflects the security intrinsic value and is derived based on fundamental analysis. The conviction rating reflects uncertainty associated with the security fair value and is derived based on broad factors such as underlying business risks, contingent events and other variables. Both the fair value and conviction rating are then used to form a view of the security potential total return. A Buy call implies a potential total return of 10% or more, a Sell call implies a potential total loss of 10% or more while all other circumstances result in a Neutral call.

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