In this podcast, Motley Fool analysts Dylan Lewis and John Rotonti take a look at two companies that are expert capital allocators and one company that's made some expensive buybacks.
They discuss:
- The only four uses for free cash flow.
- Why management teams often struggle to do share repurchases well.
- How Apple became a "shining example" of superior capital allocation.
- One less familiar company that's executed buybacks well.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on Nov. 05, 2022.
Dylan Lewis: It's hard to understate how excellent that program has been and how massive it's been. I mean, they have bought back in their own stock the equivalent of most companies market caps many times over.
John Rotonti: Most. I mean, they bought back more than a Visa, Dylan.
Dylan Lewis: It's incredible.
John Rotonti: They've bought back more than a Visa.
Chris Hill: I'm Chris Hill, and that's Dylan Lewis and John Rotonti. Buybacks are one of the best ways to return capital to shareholders, but only if they're done well. On today's show, we're taking a look at share buybacks and the companies giving you a larger slice of the pie. Dylan and John zoomed in on two companies that have done a great job of buying back their own stock and one that may have made some expensive mistakes.
Dylan Lewis: Before we get into the nitty-gritty, I think we should probably spend some time talking about what we're talking about with capital allocation and specifically what capital is being allocated here by companies.
John Rotonti: To understand capital allocation and the priorities for how companies allocate their capital, we first need to define free cash flow because that's where capital allocation comes from. Free cash flow is the cash flow available to all claimholders, so both equityholders and debtholders, after the company has reinvested in growth, so after the company has invested to maintain and grow its assets. One of the things that I think a lot of investors misunderstand is they think that companies are reinvesting their free cash flow. That is incorrect. Remember, free cash flow is after reinvestment, and that reinvestment takes the form of anything, research and development, working capital, capital expenditures, even acquisitions.
Free cash flow is the free, unencumbered cash that is leftover after investing for growth. There's only four things that company can do with that free cash flow. One is it can pay a dividend. Two is it can pay down debt, repay debt. Three is it can repurchase stock or buyback stock. Then four is it can let it build up on the balance sheet. There are no other uses for free cash flow. The most creative companies in the world could not come up with another use. Those are the only four uses of real true free cash flow. Then the question of capital allocation is, how does a company prioritize those uses? Does it prioritize dividends? Does it prioritize paying down debt? Or does it prioritize buying back stock, which is what we're going to dive into here today?
Dylan Lewis: Yeah. I think the reason that this is so important and why capital allocation is so often directly associated with the management team is it gets outside of a little bit of the day-to-day of the business and starts to focus a little bit more on what the business is building too and also financially how this business wants to exist, wants to sell itself to people in the market. Do they want to be known as a company that pays a dividend? Do they want to be an aggressive repurchaser of their own stock? Do they want to be a company that is aggressively shoveling money into their marketing and then not even having the option and deciding through these things? It's a way that we can zoom in on the financials to understand some of the priorities of management teams.
John Rotonti: You're exactly right. When we do a deep dive into the cash flow statement, each of the potential uses of free cash flow is a line item on the cash flow statement. Repay debt is a line item on the cash flow statement. Common dividends paid or total dividends paid is a line item on the cash flow statement, and repurchase of shares is a line item on the cash flow statement. So if you look at the cash flow statement, you can literally see what a company's capital allocation priorities are. You don't have to ask management, it's right there. If they're spending more every year on buybacks and dividends, you can see that buybacks are a priority. If they're spending more on dividends and buybacks, you can see dividends are a priority. Warren Buffett, Dylan, has shared his thoughts on the most value accretive uses of free cash flow. Here's one or two quotes from Buffett himself in his 2012 letter to shareholders.
He says quote, "We like increased dividends and we love repurchases at appropriate prices." Two other quotes from his, well, this is also one from his 2011 letter to shareholders, "It doesn't suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation, whether the money is slated for acquisitions or share repurchases, is that what is smart at one price is dumb at another." Then finally, my last quote also from Buffett, "Repurchases is sensible for a company when it shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently. It's hard to go wrong when you're buying dollar bills for 80 cents or less." There's Warren Buffett himself saying repurchases are the single best use of capital when done intelligently, Dylan.
Dylan Lewis: I like that Buffett specifies in that first quote. He likes dividends, loves share repurchases. A big part of that, John, is the dividends are great. You can receive a payment. Sometimes it's a onetime payment, sometimes it's an ongoing payment from a company, but that is generally seen as a onetime use of cash, whereas buybacks create an ongoing benefit for shareholders and for the company.
John Rotonti: They create an ongoing benefit for continuing shareholders, shareholders that don't sell out, if done at appropriate prices. Yes, that's 100 percent correct.
Dylan Lewis: I think to zoom in on the mechanics here, we're talking about going out and removing the number of shares outstanding or reducing the number of shares outstanding. The reason that that can continue to benefit people who continued on the stock is your stake in the business gets a little bit bigger. You own a little bit larger piece of the pie with these companies. Before we start getting into some examples of companies that have done this well and companies that have not necessarily done this so well over the last years, the prevailing thought and the reason that I think people are willing to give management teams leash to buyback shares is in addition to the economic benefits, John, we typically think of management companies as being as dialed in and as aware of the health of their business as anybody. Who better to be making decisions about being able to buyback shares and allocate capital correctly than the C-suite? Otherwise, why would they be there?
John Rotonti: You're exactly right, Dylan. You would think management understands their company best, the company prospects best, and also the intrinsic value of the business best. Unfortunately, there's data, there is research showing that a lot of times, corporate America will buyback stock at the wrong time. They will buyback the most stock when stock prices are high and surging, and then they will take their foot off of the buyback pedal when stock prices are attractively valued and falling. There's many reasons for that. One is psychological. When everything is going well and your stock's going up, you think it's going to continue to go for a while. That's its recency bias, it's a psychology thing. The other reason is incentives. Sometimes management teams are not incentivized to do what is best for long-term value creation and long-term shareholder value. Sometimes they are not incentivized to increase earnings per share over a short period of time. One way to do that may be to repurchase stock, even if it's at a high price. Those high priced buybacks could destroy value in the long-term, but inflate earnings per share in the short-term. It also comes down to incentives.
Dylan Lewis: We're going to try to learn a little bit here. Learn from the best. Maybe learn from an example or two more recently that I have some issues with. Let's start with one of those shining examples. There is, I think one company that immediately comes to mind, John, when you think about share repurchases. It is simply just because of the scale that they have bought back stock on over the last decade, and that's Apple.
John Rotonti: It's Apple. I think it's also a great segue because we were just talking about Warren Buffett and his thoughts on buybacks. It also happens that Apple is his largest stockholding. I don't know if it's 150 billion or where it is, but it's a very, very large amount. He says he loves buybacks at appropriate prices. That was a Buffett quote. Apple is an example of that. They started buying back stock in 2012 and since then they've purchased a trillion dollars worth of their stock. By the way, it's allocated about another $100 billion to dividends over that time period, but we're going to focus on the buybacks here. Right now, Apple is allocating about $90 billion a year toward buybacks and other 14 billion toward dividends. Over that time frame, basically, their fiscal 2013 through fiscal year end 2021, Apple's fully diluted shares outstanding have gone from about 26 billion to about 16.8 billion.
Apple has bought back over 35 percent of shares outstanding and has been reducing the share count by an average of about five percent per year over the past decade. This is real return of cash to shareholders and not just buying back stock to offset dilution. Apple spent about $486 billion buying in 9.2 billion shares fully diluted. That's an average price of about $53 per share, Dylan. Fifty three dollars is the average price Apple has paid to buyback stock. If you want to round up to 55, let's just do that. Round up to 55, that compares to a stock price today of about $145 per share. Apple is a shining example of superior capital allocation. I cannot think of a better CEO for where Apple is in its life cycle than Tim Cook. He is just doing a fantastic job with both operating the business and capital allocation.
Dylan Lewis: It's hard to understate how excellent that program has been and how massive it's been. They have bought back in their own stock the equivalent of most companies' market caps, many times.
John Rotonti: No. They bought back more than a Visa, Dylan.
Dylan Lewis: It's incredible.
John Rotonti: They've bought back more than a Visa. It's incredible. Visa does not have a market cap of 500 billion.
Dylan Lewis: To put some numbers to what that does. Look over the last five years, 2017-2022, company's net income has gone from about $48 billion to $99 billion.
John Rotonti: Wow.
Dylan Lewis: Over that same period, earnings per share have gone from $2.32 to trailing 12 months, $6.10 on basic EPS level. Your earnings-per-share growth is outpacing net income because the number of shares that you're out there with have gone down. I think one of the other interesting elements, and this gets lost just because Apple's dividend is so small, the yield is so small even though the payment itself is actually quite large. Apple's dividend per share is up 30 percent from 2018, so on a per share basis. The total amount of money that Apple pays in dividends is only up seven percent during the same period.
John Rotonti: Per share value
Dylan Lewis: Yeah, 4.5 billion shares have been retired over that time. It's been an ongoing benefit because people own more. It also means that the company hasn't had to pay out nearly as much overall to satisfy the requirements. They've been able to grow their dividend.
John Rotonti: Yeah, Dylan. Just to put some numbers on it, like you said, through their fiscal year end 2021, their net income grew at a five-year compounded annual growth rate of 16 percent. Their earnings per share grew at a compound annual growth rate of 22 percent. The Delta between the 16 percent growth in net income and a 22 percent growth in earnings per share was from buybacks.
Dylan Lewis: That's real. That is a real benefit that shareholders feel appreciated and it's demonstrated in the performance of the stock. It's the largest company in the world. If you look at how much their market cap has increased compared to their stock price, the stock price has gone up a lot more because of those buybacks. Apple will be the first company to return one trillion dollars in capital through dividends and buybacks.
John Rotonti: It's hard to believe.
Dylan Lewis: We followed the story for a while. This is not new, this share repurchase program. I think even five years ago, if you told me that that was the number they were going to hit, I'd have a hard time believing you.
John Rotonti: Yeah, totally.
Dylan Lewis: The Apple share repurchase story is, I'll say a little well-won, John. People know it. I also want to give people maybe a story that they're a little bit less familiar with as an example of share repurchases done well.
John Rotonti: I would say even done better than Apple. The example I have is O'Reilly ticker, ORLY, that's O'Reilly Automotive. This is a company that I tweet about all the time because it's one of my top holdings. It has increased it's return on invested capital for 12 straight years. That is driven by an upward trend in both its no-pat margins or net operating profit after-tax margins and its invested capital turnover. Basically, that means the increase in return on invested capital is coming from higher profit margins as well as better balance sheet efficiency. It also has a negative cash conversion cycle and generates more free cash flow than it knows what to do with.
Its core earnings, Dylan, have grown every year for 23 consecutive years, yet a lot of investors think it's going to be disrupted or something like that. If it is, that disruption is happening at a glacial pace. In the meantime, the company continues to grow profitably at extremely high returns on invested capital, year-in and year-out. I've owned it for a decade. I've owned for longer than I've owned Apple. People have been telling me, Dylan, to sell this stock the entire time I've owned it for over a decade because EVs are going to put the company out of business. I just keep ignoring them honestly and thank goodness, because have you seen how well the stock price has held up this year when pretty much everything else is getting smashed? Anyway, O'Reilly is, just like Apple, a superior operator and a superior capital allocator.
It does not pay a dividend. Apple pay to dividend, O'Reilly does not pay a dividend, so its priority for allocating free cash flow is clearly share repurchases and paying down debt, but we're going to focus on the buybacks here. It started buying back stock in 2011 and through year end 2021, it has spent $16.7 billion buying back 67 million shares. Over that time, its fully diluted share count went from 137 million down to 70 million. It reduced its shares by 67 million. That means that over those 11 years, it repurchased stock at an average stock price of about $250 compared to its stock price today of about $800. Over that time they repurchased 49 percent of its shares outstanding and reduce the share count by an average of about seven percent per year. I mean, Dylan, you cannot make this stuff up.
Dylan Lewis: It's incredible and it's a put plainly. People who have owned the stock that entire time have seen their share of the business essentially double.
John Rotonti: Yes. That's exactly right.
Dylan Lewis: Which there are not very many businesses you can say that for.
John Rotonti: No, and you didn't have to buy that, you'd have to buy an additional share. Your ownership of the business doubled just because of the buybacks that company is doing on your behalf if you're continuing shareholder.
Dylan Lewis: I'm curious John, O'Reilly is a little bit of a lesser known name. Was this something where you were following the company, interested in the company, and then found that they were good capital allocators? Or did you becoming a shareholder start with identifying that they were great capital allocators and then getting interested in the business?
John Rotonti: I don't remember exactly. It's a really good question. I've owned it for over a decade, like I said. I do remember how I first came across it. It was owned by Chuck Akre at the time and so I was reading one of his letters or I had seen one of his interviews. He said he was an owner of O'Reilly Automotive and then I started doing my research. I assume that at some point, doing my research a decade ago, I discovered they were a pretty good capital allocator and over those last 10 years, I think they've gotten even better. Probably a little combination of both.
Dylan Lewis: To turn things around a little bit and look at some buybacks that I think probably haven't gone quite as well or maybe buybacks done poorly. This may not be a surprise for folks that been following earnings season in the new cycle recently. Meta has been catching a lot of bad headlines, John, and I think that their buybacks over the last 12-16 months have not been great to put it mildly. The company has spent $48 billion in repurchasing shares, roughly 158 million shares, as part of that. This was all prior to them reporting earnings. Roughly an average price of $300 a share.
Now after a disappointing earnings report, we are seeing shares at around $100 and we know that from the recent earnings report they bought back another 6.5 billion in the most recent quarter. We're looking at over $50 billion over the last, we'll call it 16 months, that they've repurchased, most of which at multiples from where the stock is right now. I think it's hard to know for sure until we're years out, in the same way that it takes a while for us to know as individual investors whether our thesis has played out and we need 3, 5, 10 years but I would just look at those numbers and say, I'm not sold, that those were great capital allocation decisions by this management team.
John Rotonti: Yeah. They definitely look poorly timed. In the very least, they look poorly timed. I guess two things I'll say about this is while they were doing these buybacks over the last 12, 18 months, like you said, I read a research report from Poland Capital, which excellent stock-picking firm based out of Florida and they did some of the parts analysis on Facebook and they said that they thought core Facebook, so not Instagram, not WhatsApp, not metaverse, not Oculus. They thought core Facebook was trading at four times earnings over the last year and so that's cheap. That's really, really cheap.
Dylan Lewis: That's incredibly cheap.
John Rotonti: Based on their analysis. I'm sorry, Meta. Maybe Meta executives had a similar analysis and thought that their stock was incredibly undervalued and so they bought back $50 billion worth of stock. On the other hand, they are going through a massive business model transformation. It's uncertain how it's going to play out Dylan. It's uncertain how it's going to play out. When going through such a transformation, that is not only uncertain, but extremely capital-intensive. One could argue that Facebook should have conserved some of its cash flow just because it's doing something so uncertain.
Dylan Lewis: I think that's part of my issue with it honestly, is the headline is they could have bought back 2-3 times as many shares as they did.
John Rotonti: Yeah.
Dylan Lewis: With that same amount of money based on the levels they're at right now. I have to think that at some point in late calendar 2021, early calendar 2022, when the vast majority of these repurchases were happening, the management team there was probably starting to see some indications of a business slowdown. That would be my guess.
John Rotonti: It's more than a slowdown. Apple privacy changes disrupted Meta's business model. It disrupted the business model. Along with a lot of other advertising, digital advertising businesses, mobile first digital advertising businesses and so yes, it's more than a slowdown. It's a business model disruption in my opinion.
Dylan Lewis: The company was trading at all-time highs in late 2021 when a lot of these repurchases were happening and so I think strictly on a financial basis, I think you could easily criticize the decision.
John Rotonti: I agree.
Dylan Lewis: But John, I think you're right. I think the meat of this and the frustrating part of it is they had a lot of cash on hand, and it's a lot easier to try things out when you have a lot of cash on it and they decided that in addition to a massive strategic pivot and a pivot that was going to require a lot of spending.
John Rotonti: Yeah, a lot.
Dylan Lewis: A lot of spending on highly speculative business lines kept. They were also going to put tens of billions of dollars to work buying back shares in excess of any stock-based compensation. This was aggressive buybacks. These were not buybacks that were simply keeping the share count roughly where it should be.
John Rotonti: It was very aggressive. Like we said, at a very uncertain time in the businesses life, they don't look good right now, don't they? They don't look good. It's going to take a while to see where the stock price ends up and how these buybacks turned out.
Dylan Lewis: I mean, what's incredible is for dogging them on this capital allocation decision, the company has $40 billion in cash sitting on the balance sheet.
John Rotonti: Forty billion in cash, what against like 20-ish billion in debt and leases. I haven't looked but I think it's about 20.
Dylan Lewis: Yes and I think 10 billion of that is new. They just put out their first-ever bond offering, which is another reason I was surprised by the share purchase program. You indicate that, not you Meta indicates that was to fund buybacks and also company investments. I would rather, if that's the route they're going to go scale back on the buybacks.
John Rotonti: I agree.
Dylan Lewis: Focus on high conviction business ideas and if you're going to be aggressive with buybacks, paste it out and be able to do it during a period where your company stock has fallen dramatically.
Chris Hill: As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.
