Buybacks Aren't the Problem for Apple

Apple, (NASDAQ: AAPL  ) stock fell nearly 10% following its earnings report last week, leading many to speculate on what went wrong. In some sense, nothing really went wrong: Apple had record iPhone and iPad sales, and Apple's record EPS of $14.50 beat the average analyst estimate.

Nevertheless, in the search for a scapegoat, Jeff Macke of Yahoo! Finance's Breakout is pointing the finger at Apple's buyback program. In a commentary with the blaring headline, "Apple slammed! Why buybacks Are for iDiots," Macke claims that buybacks don't have any tangible benefits -- and that Apple is therefore wasting shareholders' money.

Are Apple's big share buybacks a waste of money?

This allegation is wrong-headed. It's true that buybacks aren't a cure-all for stagnant or declining businesses. If you think Apple is either one of those, than you shouldn't be investing in Apple stock just for the sake of buybacks. However, if Apple returns to growth later this year -- as I expect -- its ongoing buybacks will have created substantial value for shareholders.

EPS vs. net income
While I don't agree with Macke's full analysis, he makes a valid point that the media's singular focus on earnings per share as opposed to net income can be misleading. In fact, while Apple's EPS hit a December quarter record, the company's December quarter net income has not budged in the last two years.

In other words, Apple's EPS growth last quarter did not represent organic earnings growth: It was driven by share buybacks. EPS is calculated as (Net Income/Shares Outstanding). By reducing the number of shares outstanding -- which is the denominator of the EPS equation -- Apple was able to boost EPS without actually growing earnings.

EPS still matters
It's true that buying back shares can't boost net income. In fact, in Apple's case, the share repurchase program is hurting net income, because the company sold bonds in order to buy back shares. The interest expense for those bonds reduces net income.

However, while investors shouldn't focus solely on EPS and ignore net income, it would be equally wrong to focus solely on net income while ignoring EPS! By reducing the share count, share buybacks give each remaining shareholder a larger ownership position of the entire company.

A year ago, when Apple was dividing up its earnings among each share (i.e. calculating EPS) it had to split each dollar of earnings among nearly 950 million shares. Today, it only has to split that dollar among 900 million shares. That means each share is getting over 5% more of the company's profit.

The value of buybacks
A few years before his death, Steve Jobs asked legendary investor Warren Buffett for advice about what to do with Apple's growing cash stockpile. Buffett told Jobs that if Apple stock was undervalued, the best option would be to buy back shares. Share buybacks add value for long-term investors in an undervalued company, as they will own a greater percentage of the company when the market finally catches on to its true intrinsic value.

Following Apple's recent stock slide, its shares sell for a little more than 12 times trailing earnings. That's significantly below the average for public companies in the U.S. Unless Apple has worse growth prospects than the average company out there, its stock must be undervalued -- making this an ideal time for Apple to buy back even more shares.

Apple spends more on R&D each quarter today than it did in the two years before it introduced the iPhone (Photo: Apple)

It's certainly possible that Apple has peaked, but it doesn't seem very likely. Apple bears who claim that buybacks are a sign that innovation is dead at Apple miss the fact that Apple is spending an ever growing amount on R&D. In 2005 and 2006 -- when Apple was developing the iPhone -- Apple spent a 2-year total of $1.25 billion on R&D . By contrast, Apple spent a whopping $1.33 billion on R&D last quarter alone!

This suggests that there are plenty of new products and services in the pipeline at Apple for the next few years. Beyond that big hint, Apple CEO Tim Cook has repeatedly stated that Apple will be entering one or more new product categories this year. Moreover, there are growth opportunities left within Apple's existing product lines, such as the recent agreement to bring the iPhone to China Mobile.

Foolish bottom line
If Apple's net income never budges from where it sits today, than share buybacks alone are not going to generate much EPS growth. However, if Apple is getting any value at all from its $5 billion annual R&D budget, the company should be able to resume organic earnings growth by releasing new products (and to a lesser extent, riding the wave of growth in global smartphone and tablet sales).

Share buybacks aren't the reason why Apple stock has lost its momentum -- but they could be the solution. Apple stock has fallen to a level that implies its has no growth prospects whatsoever. However, if a return to growth is on the horizon, the best thing Apple's management can do today is to buy back more stock. (That would be much better than rushing a half-baked new product to market, for example.)

Shrinking the share count now will accentuate the impact of organic earnings growth on Apple's earnings per share next year and beyond. If you are a long-term Apple investor, presumably you believe that the stock is undervalued. If that's true, bigger buybacks today will create even bigger upside tomorrow for Apple stock.

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  • Report this Comment On February 02, 2014, at 12:15 PM, AmosTuck wrote:

    You write:

    "It's true that buying back shares can't boost net income. In fact, in Apple's case, the share repurchase program is hurting net income, because the company sold bonds in order to buy back shares. The interest expense for those bonds reduces net income."

    This observation is untrue.

    Since the dividend yield on Apple's repurchased shares was higher than the weighted coupon of the debt it issued, Apple's net income is higher because of the repurchase program. Apple saved almost a billion dollars in cash per year by borrowing money to buyback those shares!

    Furthermore, the increase in net income from the repurchase program is amplified by the fact that interest expense is tax deductible, while dividend payments are not. The yield on the equity was 2.5% at the time of the debt issuance; the weighted coupon on the debt was 2%; and the interest Apple pays on the debt is all deductible.

    Apple's execution of this leveraged recapitalization, even on a minor scale, was utterly brilliant.

    Interesting article though.....many thanks!

  • Report this Comment On February 02, 2014, at 2:51 PM, DanManners wrote:

    Macke said to buy Lululemon after the CEo announced she was leaving and the stock tanked. With his normal arrogance, he said it will come back. Well we know how that ended up.

    If you a nice business and you make 500,000 and your partner makes 500,000 and you buy your partner out, you now make $ 1,000,000. Is that bad to do?

    EPS goes up. If Apple made $12 billion a quarter on top of present dividends and buybacks and put that back towards more buybacks, you have more EPS plus you have to pay out less dividends. So you save money there. Eventually the person owning the last share will do quite nicely.

    You can always issue shares if you need money. You can reverse it. If the stock goes to $ 1000 due to buybacks, you can then sell stock at $1000 per share.

    If Apple is not using the money, they should do buybacks. They are better than dividends as they permanently help the company. If Apple can innovate again which I know they never will, buybacks are the answer.

    Though I did here about some major innovation coming out soon. He will have more colors for the 5C.

    Cook needs to go. That is the innovation. This guy is not the one to run the greatest company on earth. he is so not the one. Elron Musk? Maybe. But not Cook. He is an arrogant Peter Principle.

  • Report this Comment On February 02, 2014, at 3:01 PM, TMFGemHunter wrote:

    @AmosTuck: You are right that the buyback improved Apple's cash flow, because the interest payments were slightly lower than the dividend yield. (Especially after factoring in the tax deductibility of the interest payments.)

    However, that's not the same as improving net income (which is what Macke was talking about). Dividends don't show up anywhere on the income statement. They are not considered an expense, just a distribution of profit to shareholders. I hope that clarifies things.

    Adam

  • Report this Comment On February 02, 2014, at 5:03 PM, makelvin wrote:

    Buying back stocks for the company can both good or bad depending on the situation. It is always a good idea for the company to buy back their stocks whenever possible when the price of the stocks are way undervalued in the market. Buying back these stocks at the undervalued prices will significantly benefit the long term shareholders of the company.

    On the other hand, when the company's stock price is way overvalued, it would be wasting money and throwing it away by buying back the stocks. This is what happened to Dell's share repurchase program several years back when their share prices were overvalued.

    But at the current Apple stock price, it is definitely a very good idea for Apple to be buying their shares back. Long term shareholders will reap the rewards.

    As for net profit vs EPS, EPS is much better at determining the current company's value where as net profit can be better at determining growth. Technically, even net profit can be deceptive at determining true growth; instead, one should evaluate the revenue and margins together to get a more accurate assessment.

    The YOY revenue growth tells you if the company's products are still in high demand. The margin that these products made tells you whether if the high demand of the company's products were artificially created by substantially lowering its selling prices. Apple satisfied both of these in flying color; it create meaning revenue growth without sacrificing its margin. In fact, the Average Selling Prices for its products actually went up thereby clearly maintaining the company's premium brand image. Sure, the dividend payout and share buy back hurt its overall net profit a bit not to mention the fact that Apple needs to spend more money in acquisition and research to compete in a market that is extremely competitive; but the bottom-line is Apple generates insane amount of cash. The company's product still maintain high demand with an premium image branding that gets a much higher margin than any of its competitors in the same area. None of these are actually bad news.

  • Report this Comment On February 02, 2014, at 10:58 PM, P2PRG wrote:

    Thank you a very interesting article and interesting comments. The comments all seem in general agreement that at this point in time when Apple is considered undervalued for all the reasons stated then the buy back program is a good idea and should probably be extended. It is a good investment to buy something for $1 that is worth $2 as Mr Icahn says that is a "no-brainer".

    The one aspect of this whole discussion from my point of view is that Apple is not spending enough on R&D. Their R&D spending is a only about 2% of sales while large tech company competitors like Google, Microsoft, Samsung,etc are spending 10% to 15% of sales. These companies also have

    large cash piles albeit not as large as Apple's but very large non the less. Example Q4 2013 Apple spent $1.33B and Google spent $2.23 or 68% more than Apple. Apple's relatively small R&D budget may account for its long product cycles and the slow pace of introducing new categories and reoccurring income streams that would create both short term and long term growth while at the same time making the Ecosystem ever stickier.

    Expanding the R&D program outside the would help solve two other problems. This would be an opportunity to profitably use some of the locked out overseas cash that is now earning next to nothing and gain access to foreign engineering and scientific talent that is currently locked out of the US by our government's limiting of H1b visas.

    Canada has a good supply of engineering talent as does the Euro Zone and Tiawan. These areas would be excellent candidates to build and develop large R&D facilities.

  • Report this Comment On February 03, 2014, at 8:35 AM, jdmeck wrote:

    Apples only real problem is confused investors who can't make up their minds what they want.

  • Report this Comment On February 03, 2014, at 9:25 AM, TMFGemHunter wrote:

    @P2PRG: That's an interesting point. I think it makes more sense to look at the absolute numbers rather than the percentage of sales, but it's still true that companies like MSFT and GOOG are spending more on R&D.

    However, Apple has always been a more focused company than pretty much any of the other major tech firms. It really has just a few product lines, and even if it added a couple of things to its product portfolio, it wouldn't be anything like the sprawling empires that are MSFT and GOOG. As a result, it really shouldn't need the same level of R&D spending.

    Apple has been increasing R&D spending at a crazy rate in the last few years: something like 30% or 40% growth on average. Just from an organizational perspective, I'm not sure that Apple could have productively increased its R&D spend any faster than that.

    Adam

  • Report this Comment On February 03, 2014, at 6:40 PM, cmalek wrote:

    "By contrast, Apple spent a whopping $1.33 billion on R&D last quarter alone!

    This suggests that there are plenty of new products and services in the pipeline at Apple for the next few years."

    It suggests no such thing. All it says is that Fruitco increased their spending on R&D. For all we know they are spending that money on lavish employee parties. We can only hope that "there are plenty of new products and services in the pipeline" for that money.

  • Report this Comment On February 04, 2014, at 9:29 AM, TMFGemHunter wrote:

    @cmalek: I disagree. It absolutely suggests that there are new products in development. It doesn't prove it; it's also possible that Apple is just wasting $1 billion per quarter as you intimate. But that seems like a less likely possibility than the alternative that the R&D spending is actually going towards research on potential products and services.

    Adam

  • Report this Comment On February 04, 2014, at 10:37 AM, CoreAndExplore wrote:

    This is such a good article, thanks Adam. I'm constantly amazed at the lack of understanding regarding buybacks, even from some analysts! While buybacks can be considered "financial engineering" in certain circumstances, especially when expensive debt is used to finance them, they can also be very accretive to shareholder wealth over time. Gaining a growing share of a company's earnings is very valuable, especially if organic earnings growth is to occur in the future.

    Apple did the right thing with this repurchase program, and was incredibly prudent to borrow $17 billion when rates were at their lowest point. I agree with Carl Icahn's sentiments, if not his exact figure of $150 billion. Apple's enormous $160 billion cash pile gives the company unprecedented buying power, which should definitely be put to use with increased R&D, increasing dividends, and large revolving buybacks. I'm also interested in Apple's rumored mobile payment system and possible deal with Ebay. I know Cook said that they will never get into financial services, but with the amount of equity and cash they have in reserve, it would be foolish not to at least consider building an entity ala GE Capital.

  • Report this Comment On February 04, 2014, at 11:24 AM, Mathman6577 wrote:

    Back in the "old" days when Peter Lynch was running the Magellan fund it seemed that earnings (however it was measured -- EPS, etc.) was one of the big drivers (along w/ debt levels) for the stock price. Now it seems EPS or net income takes a back seat to other parameters (some of them intangible).

  • Report this Comment On February 06, 2014, at 1:29 PM, cmalek wrote:

    Adam

    "I disagree. It absolutely suggests that there are new products in development. It doesn't prove it"

    You may disagree all you want but the evidence you presented would not hold in any court or a lofic debate.

    It "absolutely suggests" new products only to Fruitco Fanatics. To others it only shows an expenditure of $1.3 B/quarter.

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