Apple Stock Buybacks Will Pay Off for Shareholders

Last week, Apple (NASDAQ: AAPL  ) reported June quarter EPS of $7.47, about 2% ahead of the average analyst estimate. Apple also provided September-quarter guidance that suggested the company will report a bigger-than-expected profit decline. Despite these mixed signals, Apple stock has gone on a tear over the last week, rising approximately 8% in that time frame.

AAPL Chart

Apple stock 1-month price chart. Data by YCharts.

While it's true that Apple will ultimately have to produce innovative new products to deliver strong returns for shareholders, the company's share buyback will provide a powerful catalyst for the next two to three years. By reducing Apple's share count, the company's share repurchase program -- in tandem with a return to organic earnings growth -- will boost EPS. Indeed, Apple is likely to generate strong EPS growth in FY14, sending Apple stock significantly higher.

Unexpected news
Going into last week's earnings report, everybody in the market knew that Apple had sold $17 billion of corporate bonds in late April to help finance a buyback that will ultimately total $60 billion by the end of 2015. However, outsiders did not know what to expect in terms of the timing of Apple's stock buybacks. In fact, based on comments made by Apple CFO Peter Oppenheimer on the April conference call, listeners could have concluded that Apple planned to spread the $60 billion buyback evenly over the next several years.

Instead, Apple has been in a big hurry to buy back its stock. The company spent a whopping $16 billion on share repurchase activity last quarter, on top of a $2 billion accelerated share repurchase program that ended in April. These buybacks caused Apple's diluted share count to drop from 947 million in the year-ago quarter to 924 million last quarter.

Moreover, Oppenheimer stated that last quarter's buyback activity will cause the Apple share count to decline by another 11 million this quarter, even if the company does not repurchase any more shares between now and the end of September.

Buybacks drive EPS
Repurchase activity on the scale of Apple's ongoing program can have a significant impact on EPS, especially over time. Looking just at last quarter, Apple reported EPS of $7.47, beating estimates by $0.15. However, if the diluted share count had remained flat at 947 million, Apple would have reported EPS of $7.29, missing the average analyst estimate. In other words, the buyback made Apple's mixed June-quarter performance look a lot better, and was therefore a big contributor to the recent Apple stock rally.

Looking forward to FY14, if Apple earns net income of $40 billion -- roughly in line with the average analyst estimate -- the buyback will have an even more noticeable effect on EPS. Based on last year's diluted share count of a little more than 945 million, net income of $40 billion would equate to EPS of $42.31.

By contrast, if the diluted share count falls to 913 million next year -- which assumes that Apple's share count falls by 11 million next quarter due to already-completed buyback activity but no other shares are repurchased -- EPS would rise to $43.81. If the diluted share count fell twice as far due to more buybacks over the next year, EPS would jump to $45.51.

EPS growth may surprise you
Apple stock's collapse over the last few months of 2012 and the first half of 2013 left the stock dramatically undervalued. That's why I doubled down on Apple stock late last month. With such a depressed share price, a relatively modest earnings beat -- driven entirely by share buybacks -- was enough to spark a nice rally in the stock.

As I've discussed in other articles, Apple is likely to return to earnings growth next year due to stabilizing margins (and possibly new products). The company's buyback will leverage that earnings growth into even faster EPS growth in FY14 -- enough to easily surpass the average analyst estimate of $42.48. This trend change will reveal just how attractive Apple stock has been at sub-$500 prices.

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