David Einhorn’s “Go Ups” – a first look (Microsoft Example)

David Einhorn is a guy which is clearly moving the markets these days. When he spoke at the famous Ira Sohn hedge fund conference last week, he even managed to move a stock by not speaking about it (Herbalife).

However, the second part of his presentation which I linked to in the “Weekly links” did not get so much attention but for me, as a Corporate Finance/ capital structure guy is much more interesting:

The “Greenlight Opportunistic Use of Preferreds” – Short Go Up.

First thing to notice: If you want to promote something, make sure you have a great acronym for it…….

Those “Go Ups” should work as follows:

1) A company creates a new class of preferred shares which have a liqidation preference and carry a 4-6% coupon hich only has to be paid at full discretion by the issuing company (although he mentions unpaid coupons are “cumulative”)

2) Those pref shares then get distributed “for free” to the shareholders like with a normal stock split

His basic argument to support is very simple and sounds convincing enough:

There are many great companies with great balance sheets that suffer from low valuation multiples in the current environment, when market participants have enormous appetite to pay for yield, but little appetite to pay for earnings. The traditional advice to such companies is to offer a dividend, but dividends often don’t work. A stock with a low P/E multiple often just becomes a stock with a low P/E and an attractive dividend.

He then adds a spreadsheet which shows his assumption for a couple of cash rich companies like Apple, Microsoft, Dell, Marvel and GM.

To take Microsoft as an example, he calculates the following way:

Microsoft has now a share price of USD 30.21 USD and a market cap of 255 bn USD. With 6.56 USD cash per share and an estimated 2.84 USD Earnings for 2012, you get an P/E of 10.6 including cash and 8.3 excluding cash.

In the next step, he assumes that Microsoft will issue 250 bn of “Go Ups” carrying a coupon of 4% and distributes them pro rata to shareholders (so shareholder would get a nominal of around 30 USD pref on top of the existing shares).

When he then compares the result with the initial market cap, he makes the following assumptions:

1. the 4% pref share trades at par
2. the Microsoft Share trades at the initial “after cash P/E mupliple” of 8.6 based on the reduced earnings (1.66 USD after ref share dividend) plus the unchanged cash position

The sum of that than is 65% higher than current market cap and this is “value unlocked”.

So let’s stop here and summarize what Einhorn is proposing:

If you divide existing cashflows of a company into two seperate securities, the “sum of parts” will be significantly higher than the previous security. This is of coure a punch in the face of all “efficient market” fans who would argue (apart from tax effects) that in theory the total value (Enterprise value) of a company does not change due to capital structure.

So let’s quickly look at the main assumptions of Einhorn which support his case:

1. Equity multiple

His argument is: The stock will trade at the same multiple before and after the “spin off” of the preferred. I would argue that this is at least “optimistic”.

Somwhere in the presentation he mentions that the preferred dividend should be cumulative, meaning that non paid dividend will accumulate and have to be paid at a later date. This is important !!!

If we go back to the Microsoft example, we have the following EPS before and after Go Ups:

2.84 USD per share before Go Up, 1.66 USD after Go Up (1.18 are Go Up interest).

So what happens, if the profit of Microsoft for some reasons falls by -20% ? Without go ups, of course profit per share drops by 20% to ~2.27 USD per share.

With Go Ups, however, we have to distribute the 2.27 USD between the fixed interest of Go Ups (1.18) and shares which results in a 1.09 EPS including Go Ups. Not surprisingly, the change in EPS of (1.66-1.09) = -0.47 is percentage wise much higher with (0.47/1.66) =-27%.

So his first assumption implies that shareholders are indifferent about a higher leveraged EPS which I think is unrealistic.

2. Valuation of Pref share

Einhorn assumes,that the Go Us will trade at par after issuance. How realsitic is that ?

A 4% Microsoft pref share will have a duration of around 26 years. This is even longer than a 30 year treasury bond. 30 Years treasury yield at the moment is around 3%. So Einhorn assumes a 30 year (deeply) subordinated spread for Microsoft is only 1% p.a.

I don’t know how realistic this is, but a deeply subordinated security is of course much more risky than a corporate bond. For instance if Microsfot starts to issue more senior bonds, the subordinated bonds get less and less liuidation value.

It is also important to mention, that such a Go up will react quite sensitive to any changes in interest rates or credit quality of the underlying. If for instance 5% would be th correct yield, with a constant duration of 26, the Go Up will drop 26% in value.

So to summarize this:

Einhorn’s underlying assumptions are very very “optimistic” if not to say (totally) unrealistic. So why is he doing this ? He is for sure one of the smartest investors alive and knows all this stuff much better than I do ?

I think his startegy could work quite well in the short term:

Under his proposal, “normal investors” of course would feel richer. Imagine, you own a Microsoft stock at USD 30 and you suddenly get a 30 USD bond “for free”. The bond (Go up) will be very difficult to value. This leaves a nice “window of opportunity” for the smart guys to profit from mis pricings as the stock price might not dirctly reflect the “true discount” and the Go Ups might trade above “intrinsic value” for some time.

So Einhorn basically tries to create a what I call “special situation” where normal share holders most likely do not know what to do or value the secrities correctly. I am pretty sure, in the long run this will not increase the total Enterprise Value of the sample companies. But in the short run, it could create a nice arbitrage opportunity for hedge funds like Einhorn’s Greenlight and give the stocks a “quick pop”.

As Einhorn owns most of those stocks, one could summarize Einhorn’s proposal as “talking his own book”. Perfectly fair but one should be aware of this. I nevertheless highly doubt that this is changing the theory of Corporate Finance…..

9 comments

  • Ferdinand,

    thanks for mentioning the Graham example. I have to look this up again.

    MMI

    • Ferdinand,

      Thank you for the comment. Can you please explain what you mean by ” This is similar to Ben Graham’s proof of undervaluation that has a company with a pristene balance sheet create corporate bonds of equal value to their market cap and distribute them to shareholders as a dividend in kind.” ?

      Do you mean Apple should issue “free” preferred stocks with maturity?

  • That’s correct. Perhaps using long only equity funds would be better to counter your example. Due to forced selling it will create an arbitrage situation at the expense of index funds. This special situation is not where the shareholder value comes from however as it’s shareholder zero-sum.

    Shareholder value in Graham’s case is created by what I can only call “category arbitrage”. The bond market values a cashflow at x, whereas the stock market values it as way less then x. Issuing bonds as a dividend in kind is a way to bridge this gap, thereby increasing enterprise value without reducing risk for shareholders. As long as the bonds fetch the going market rate and the equity is worth more than zero, shareholder value has been created.

    What this shows is that markets are a wealth transfer mechanism from those whose hands are tied to those whose hands are free. If as an investor you’re bound by categories that do not adequately represent the underlying risks and cashflows you’re paying someone else for that mistake.

    This is why I believe that Einhorn is right about the possibility of creating shareholder value by recategorizing cashflows. It’s just that he’s wrong about the categories. The disparity is between finite and infinite maturation.

  • Index funds will be forced selleers, as they are not allowed to hold bonds. They only will be able to reinvest proportionally to the weight in the index which will not change.

    So you will have a “forced sale” special situation, exactly those situations where guys like Einhorn (and sometimes myself) can make money.

  • What reason do you have to think that the index fund wouldn’t be able to get a fair market value for their bonds? They could sell the issued bonds and reinvest the funds into the stock. This increases their risk because they’re no longer first in line at a bankruptcy, but they are compensated for this risk by effectively lowering their cost base to zero.

  • From the shareholders perspective it doesn’t matter if the company goes bankrupt. Their debt would just convert to the equity they’re already holding.

    The equity value might be discounted in the market to price in the added risk of leverage, but it won’t be fully discounted. As long as the equity is not fully discounted shareholder value is created.

    • This is not correct, as many share holders won’t be able to hold the bonds, for instance index funds etc. So you will pretty soon see that bonds and stocks are held by different inevstors. This is basically the main argument of Einhorn. And then the trouble will start

      As I said in the post, short term this might work, long term it will kill at least some of the companies.

      mmi

  • #Ferdinand,

    thanks for the comment. With regard to maturity:

    What does the comapny do at maturity ? It has to roll the bonds. If it cannot roll, it is bankrupt.

    That is what happens all the time with Private equity etc.

    It doesn’t matter how one calls it, leveraging is leveraging and ussually it ends badly.

    MMI

  • This is similar to Ben Graham’s proof of undervaluation that has a company with a pristene balance sheet create corporate bonds of equal value to their market cap and distribute them to shareholders as a dividend in kind.

    In this scenario it’s not about creating a special situation, it’s about creating a new perspective for the market to evaluate a company’s cashflows. If there is truely a mispricing in the stock then the newly issued security should trade at par, thereby creating shareholder value.

    What Graham understood but Einhorn does not, is that you need to give the newly issued security a maturity. Stocks are basicly bonds that have infinite maturity and this is why the market discounts their cashflows vis-a-vis bonds that have a finite maturity. Creating another security with infinite maturity (a Go-Up) is not going to change the market evaluation. Issuing Graham’s bond definately will.

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