All Companies Should Issue Apple’s iPrefs

moneyIn order to increase the sagging Apple (AAPL) stock price, famed hedge fund investor David Einhorn suggested that the company should issue perpetual cumulative preferred shares. Here is the presentation if you have not seen it. 

The basic idea is that Apple should distribute to its shareholders one of more of $50 denominated iPrefs that pay an annual dividend of $2. The shareholders can either sell them on the open market where Einhorn expects them to trade at around $50 or keep them a get 4% yield per year ($2/$50).

The main reason for the iPrefs over other ways to distribute income (dividends, share buybacks, etc..) is that it will significantly increase the value of Apple’s shares. For example, if Apple issued 10 $50 iPrefs for each share, it would have to pay an annual distribution of $20/share ($2*$10) and theoretically, you could sell the shares for $500. $500 is above todays Apple share price of around $430. If you add the earnings that are left over after the distribution ($20+share and the $137 billion in cash), Apple would probably trade around $250-$300 post distribution.

The more iPrefs Apple distributes, the higher their valuation will be. The iPrefs also have other advantages:

  • There is no default or bankruptcy in the event that Apple cannot pay the dividend.
  • Apple can wait to bring over the cash pile they have overseas and not have to worry about the tax implications.

The iPrefs will definitely unlock value. How much value will depend on two factors:

  • The number of iPrefs they issue.
  • The price they trade on the open market. I think Einhorn is being too optimistic. They will most likely trade at a 5% yield or $40/share. 

The reason the iPrefs will unlock value is that there is discrepancy between what stable high quality companies trade for and where long-term bond yields are at. With iPrefs, Apple is just levering up the company in a smart way and distributing the proceeds to shareholders.

If I was an Apple shareholder (which I’m not), I would continue to hold the shares because as the shares go down, there is a greater chance that they will issue iPrefs. I will most likely start buying the shares at around $400, if they ever get there.

Microsoft

If Apple ever does issue iPrefs, the first company I will buy is Microsoft (MSFT). This will most likely be Einhorn’s next target. It has a similar profile as Apple:

  • Tons of cash on the balance sheet.
  • Trades at less than 10 times earnings and generates tons of cash ever year.

Last quarter, Einhorn increased his stake in Microsoft by over 40% to over 10.8+ million. 

Other companies that could follow suit are other tech giants such as:

  • Cisco
  • Oracle
  • Dell (if the takeover falls through)

Eliminate dividends

I would take it one step further and eliminate dividends and issue iPrefs to take advantage of the aforementioned discrepancy. It would be a big boost to the stock market.

Disclosure: I do not own any of the companies mentioned above. 

Bought Vodafone!

Last week, I wrote that Vodafone (VOD) was one of David Einhorn’s top picks. I did some due diligence on the stock, and it seems like a great investment. 

Vodafone provides mobile telecommunications services and has significant market share in:

  • Mature European countries such as England (100% ownership, 26% market share), Spain (100% ownership, 29% market share), Germany (100% ownership, 34% market share), Italy (100% ownership, 36% market share).
  • Less Mature Asian and African countries such as India (64.4% ownership, 29% market share), South African (Vodacom Group, 65% ownership, 58% market share)
  • United States through 45% ownership of Verizon Wireless
  • Many other countries through partnerships and equity investments.

Vodafone has a market capitalization of $135 billion. Its most valuable piece is the 45% stake in Verizon Wireless. The other 55% stake is owned by Verizon.

Verizon has a market capitalization of $125 billion and long term debt of $50 billion. Verizon has two business segments:

  • Verizon Wireless. Verizon Wireless has total revenue of $80 billion. Since Verizon owns 55% of Verizon Wireless, $44 billion of that $80 billion belongs to Verizon. That $44 billion makes up about 1/2 of Verizon’s total revenue. Verizon Wireless also makes up all of Verizon’s operating income.
  • Verizon Wireline (FIOS, etc..). Wireline makes up the other 1/2 ($40 billion) of Verizon’s total revenue. It has pretty much break even operating income. 

Verizon Wireless should make up a majority of Verizon’s market capitalization:

  • Contributes to half of revenue.
  • Makes up less than less than $10 billion of Verizon’s total $50 billion long term debt.
  • Makes up all of its operating income.

Conservatively, it is probably worth around $100 billion.So, Vodafone’s ‘s 45% stake is worth around $80 billion. Einhorn argues it is worth even more.

“Look at it from Verizon’s perspective: Historically, Verizon had a very profitable landline business, and Verizon Wireless owed it billions of dollars. Verizon received Verizon Wireless’s free cash flow as it repaid the debt. For years, Verizon used its control to try to starve VOD by refusing to allow Verizon Wireless to pay dividends. Today, Verizon’s landline business generates no cash and the debt from Verizon Wireless has been repaid. Verizon’s 55% control stake in Verizon Wireless is probably worth more than all of Verizon’s market capitalization, and Verizon has become wholly dependent on dividends from Verizon Wireless to fund its parent company obligations and shareholder dividends”

The rest of Vodafone (excluding Verizon Wireless) in fiscal 2012 had FCF of $6 billion pounds or almost $10 billion. At a valuation of 10 times FCF, the rest of Vodafone is worth $100 billion. According to Einhorn, it should be valued at 12 times earnings, in line with other European Telecoms. 

So, the total value of Vodafone is $180 billion or 33% above its current market capitalization of $135 billion. 

Vodafone seems to be a great investment. There is significant upside and investors are paid to wait with the juicy dividend. 

DIsclosure: I own Vodafone

Apple Broken Down

Apple White iPhone

Let me preface this article by saying, I am a fan of Apple (AAPL) products. I own an iPhone, a MacBook Pro, and an iPad Mini. So, I am a bit biased. However, I will be objective as possible when talking about Apple as an investment. 

Apple has been the subject of heated debates from bears and bulls. Let’s first look at the bullish arguments and then the bearish argument. 

Bullish Argument

  • Apple’s valuation is cheap. At around $500/share, it has a market capitalization of around $475 billion. It has a huge cash cushion of around $120 billion. It trades at around 10 times 2013 earnings estimate. This is cheap for a company that has been growing earnings 70% a year over the last 5 years (Source: Yahoo Finance)
  •  The biggest contributor to income, the iPhone, is still the best smartphone in the market.
  • Apple products command premium price and margins.
  • Apple just had a major upgrade cycle, iPhone 5 and iPad Mini just came out.
  • The smartphone revolution is still in its infancy. According to the Business Insider in September, “There are an estimated 6 billion mobile handsets in the world, and only about 1/5th of them are smartphones.”
  • Apple is still not supported by the biggest telecommunications network in China, China Mobile.
  • Apple is working on the next big thing, Apple TV. This could be next catalyst for income and stock price.
  • Once users are in the Apple ecosystem, they tend to buy more products and apps. According to Fortune magazine, Apple is projected to generate $22 billion in App store revenue by 2016.

Bearish Argument

  • Yes, Apple is cheap based on past earnings growth. However, future earnings growth is questionable. It is hard to grow a company earning $40-$50 billion a year much less maintain it. A lot of the cash is overseas and Apple would have to pay taxes to bring it to United States.
  • It is debatable whether iPhone is still the best smartphone. Samsung is catching up or has caught up. The different between iPhone is much smaller than what it used to be a couple of years back.
  • Although, Apple’s premium price and margins have lasted in the pc industry, the smartphone industry is different. It’s a different OS (Windows vs Android) and different manufacturers. Unless, Apple makes much better smartphones, the margins will not last.
  • Apple just had major upgrade cycles, but the changes were not revolutionary. Apple’s products are not matching their hype anymore. The first quarter should be huge, but what about the rest of the year.
  • There are a lot of people without smartphones. However, most of the are not the high income Apple customers. A lot of these customers are in India and China where customers are a lot more cost conscious and will not pay a premium price for Apple products.
  • China Mobile and Apple have been working on a deal for years. Even if the deal goes through, China Mobile has a lot more leverage than other telecommunications networks and the deal will not be as favorable to Apple as with other partners.
  • First, Apple TV has to come out. Once it does, it has to be a success. Even if it is a success and say the product is worth $100 billion. That will only equate to about 20% of Apple’s current worth.
  • A projection of $22 billion generated by the App Store in 2016 is nothing especially when you consider that Apple makes 30% of that revenue. If you factor in taxes, the net income from the App Store comes out to less than $5 billion. This is nothing for company worth $500 billion.

My Take

I believe that people who are predicting Apple to fall below $300/share are foolish. I also believe that people who are predicting Apple to go above $1000/share are foolish.

I see Apple now as a value stock that will trade around the $500 range. To me it does not make sense to buy Apple because its market capitalization is so big. It would take tremendous growth and innovation to move a company worth $500 billion. I have a hard time seeing how Apple can move much higher unless:

  • They maintain their margins and gain market share in the smartphone market.
  • Apple TV is somehow a $100 billion+ product.

Having said that I don’t think there is a huge downside to the stock. I do not see it dropping below $400/share. The $120 billion cash cushion should increase to over $150 billion by the end of fiscal 2013. This should provide downside protection.

Disclosure: I do not own Apple stock.

Year end review

Happy new year! I took some time to disconnect over the last two weeks and enjoy the holidays. For the first post of 2013, I thought it might be a good to review all the picks from the last 3 months to see how I fared.

AIG (AIG)

AIG is still one of my top picks. It is up about only $2 from the price I paid for the stock. However, I feel it still has significant upside. Mainly all the arguments I made previously still apply:

  • It trades at half of book value.
  • The government completely sold AIG shares at the end of 2012. It now only holds warrants in the company.
  • AIG sold its stake in AIA. It also has agreed to sell a majority of its stake in ILFC.
  • The company can now focus on its core insurance operations and improve its return on assets.

Dean Foods (DF)

I sold Dean at a little bit of a loss. I still think Fresh Diary Direct segment is undervalued. However, the volatility of Whitewave was too much for me to take. I think the best way to play Dean is to wait for them to distribute the Whitewave shares and buy it before the distribution date if the current prices remain as they are.

General Motors (GM)

GM is one of my biggest winners. It is up nearly 50% for me. The government sold off 200 million shares of its stake in the company to GM recently. This should have a positive impact on EPS. If the economy improves in US and Europe and vehicle sales return to a normalized state, earnings could easily be over $5 over the coming years. Also, it is slowly removing the overhang of the pension liabilities. This could also be a big boon.

With the stock to almost $30, I might cut my position in half and book some profit. The auto industry is very capital-intensive and very competitive.

Orchard Supply Hardware (OSH) & Sears Hometown & Outlet (SHOS)

I have written a lot about these two Sears spin offs and I am short both. As I mentioned in my previous articles, I am convinced Orchard will go under. So far, it has been a very profitable short for me. I am not 100% convinced on Sears Hometown, so I only have a small short position there. Both of these plays are a bit risky, since they are cheap on a revenue multiple basis. Sears Outlet is a wild card for SHOS. If it can grow that successfully, the stock may have upside. I have no faith in the Sears Hometown business as it has had negative same store sale numbers for years. I know a lot fellow financial bloggers are long SHOS and I am open on seeing their analysis. So far, I have been wrong as SHOS. It has bounced nicely from $30 to $35 recently.

Xerox (XRX)

I bought Xerox around $6.50. The stock is around $7.20 today. Nothing fundamentally has changed about the company since I wrote the bullish case. It still trades at a significant discount to FCF and has increased its dividend. I still think there is significant upside.

Genie Energy (GNE)

Genie was a quick arbitrage trade on its offer to exchange common shares for prefered shares. I booked little less than a 10% profit on the trade. I still think there may be an opportunity on this type of trade in Genie in the future. Nobody will exchange the common for the preferred as the common is trading higher than the preferred.

Pandora (P)

I have a small short position in Pandora. So far, it has not been a good trade as the stock has shot up from $8 to $10. I continue to believe that this company will not exist in the future. It really has no barriers to entry, no competitive advantage, and is not profitable. Obviously, a lot of Pandoras profitability depends on the outcome of the Internet Radio Fairness Act. However, there is no doubt that there will be more competitors in this space in the future. I will keep this short position.

Susser Holdings (SUSS)

Susser is up about a $1 from what I bought it at. It may take some time for this stock to go up. However, it should be able to expand a lot faster after the spin-off of SUSP. I have a small position and will keep that position.

Others

I also missed out in some of my other bullish calls such as Facebook, Lumos Networks, Nacco Industries and Einsteins. I wrote a bearish case on Western Union, but the stock has been up since then. I still believe in the bearish case. I believe that Western Unions biggest competitor Moneygram will have a tough 2013 due to Western Unions price cuts. I will be looking to short in 2013.

DIsclosure: I own or am short most of the positions

Einsteins Special Dividend

I wrote last month that Einstein’s (BAGL) stock price could possibly appreciate as much as $5 if its proposed recapitalization transaction goes through. Einstein was proposing a $9 special dividend financed through debt.

Last week, it announced a $4 special dividend payable on December 27, 2012. The ex-dividend date will be December 28, 2012.

The stock currently trades at $16. If the shares dip to the low $15 range before the dividend, I might initiate a small position. After the special dividend, I expect the stock to trade between $12-$13. At this price, the dividend (.50/share) yield will be around $4%.

Disclosure: I do not own BAGL

Wester Union Undervalued or Value Trap?

Western Union LogoWestern Union (WU), the money movement and payment services provider, recently reported third quarter results this past week. Although the results were not bad, the outlook was grim. In order to gain market share, the company expects to take restructuring costs, and more importantly lower prices. This will lead to lower earnings for the rest of 2012 and 2013. Investor reaction was swift, knocking the stock price from $18 to $12. At a 52 week low, is the stock now cheap?

Business

Western union has two business segments:

  • Consumer-to-Consumer. As you may have guessed, this is money transfer from one consumer to an another. This segment accounted for 84% of revenue and 95% of operating income for fiscal year 2011. 
  • Global Business Payments. This segment allows clients to make “one-time or recurring payments for consumers or businesses to other businesses.” This segment accounted for 14% of revenue and 10% of operating income for fiscal year 2011. (Note: Operating income numbers do not add up because rest of company lost money.)

Moat

Although they are trying to grow the smaller Global Business Payments segment, the valuation largely depends on the Consumer-to-Consumer business. In the Consumer-to-Consumer business, Western Union is the market share leader, garnering around a 17% market share in a fragmented industry. Moneygram International (MGI), its biggest competitor, accounts for just around 5% of the market.

Although, some investors are concerned about Western Union losing market share to digital competitors such as PayPal, the core company consumer sends money to a cash receiver. In this market, Wester Union is king. Their biggest advantage or moat if you will, is that they have a global network of 510,000 agents. Moneygram has less than 300,000 agents.

Their big network and presence allows them to charge a premium rate over their competitors. In some remote parts of the world, Western Union enjoys a monopoly since they are only agents in the area. As a result, they enjoy 60% of industry profits even though they only have a 17% market share. 

It is not easy for any company create this global network, and Western Union will continue to enjoy a premium price advantage due to it.

Industry

The global remittance volume is dependent on the global economy. It has been growing at a double digit CAGR rate and is expected to grow at around a rate of 7% over the next couple of year. See figure below.

Global Remittance VolumeSource: MoneyGram from World Bank 

Valuation

With a growing industry and premium pricing, one would think that Western Union’s net income would grow through the roof. However, that has not been the case. Net income has been fairly stagnant at around $1 billion/year since 2005.

Even though Western Union enjoys premium pricing over its competitors like MoneyGram, there is general pricing pressure in the industry. As a result to keep market share, Western Union’s revenue per transaction has been going down at a CAGR rate of 4.16% since 2006.  See figure below.

Wester Union Revenue Per Transaction  Source: 10K

Western Union has been able to grow revenue, maintain margins and maintain net income by increasing the number of transactions. Number of transactions per year has been growing at a CAGR rate of 8.95%. See Figure Below.

Wester Union Number Of TransactionsSource: 10K

If I could be confident that Western Union could at least maintain net income for a long time, I could assign a multiple to FCF and come up with a valuation. However, there are a couple of things working against Wester Union.

There is the constant pricing pressure on revenue per transaction that I just alluded to.

  • Customers that need to send money back home in remote parts of the world are paying super high fees to send just a couple hundred dollars.
  • Moneygram and other competitor’s prices are already lower than Wester Unions. Moneygram’s number of agents are growing at a higher rate than Wester Unions. Although, they will not catch Western Union anytime soon, they are putting more and more pricing pressure on certain corridors.
  • The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010 already had an effect on this quarters revenue as 7,000 agents were dropped because they could not made compliant. Although, this act will not have significant revenue ramifications, there could be future acts that could have more of a lasting effect.
  • Although it does not affect Western Union’s core customers, competitors like PayPal are allowing consumers to send funds electronically very easily. In fact, PayPal and MoneyGram just signed a partnership where PayPal users can send funds to any MoneyGram location. This should have an effect on Western Union’s pricing and market share. 

The main reason for the gloomy forecast in the latest quarterly report is that management intends to lower prices to increase the number of transactions and gain back lost market share. The competitors will have to react to Western Union’s price cuts next year and they will cut prices. Then the price cutting vicious cycle will continue.

If you add the fact that global remittance volume is going to grow at a slower rate over the next 3 years than it has in the past, the best investors can hope for is that Western Union can maintain their net income of around $1 billion.If they can do that, then yes the stock is cheap at the current market capitalization of over $7 billion.

However, it is not worth investing in something that has limited upside and has so many things working against it. Therefore, even though this stock looks cheap from all valuation metrics, I am not investing in the company because I believe it is a value trap. 

Disclosure: I do not own WU.