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Duped By Earnings? Why Apple Fell

By Margie Nemcick-Cruz – Feb 4, 2014 at 9:30PM

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With Apple falling nearly 8% after releasing earnings, you'd imagine on the results must have been pretty bad, but with one quick glance at earnings per share figure (EPS) shows the company earned $14.50 a share versus $13.81 in the year ago period. What gives?

With Apple (AAPL -2.12%) falling nearly 8% after releasing earnings, you'd imagine that the results must have been pretty bad. But one quick glance at earnings per share shows the company earned $14.50 versus $13.81 in the year ago period. What gives?  

Dig deeper
This is when you have to dig just a little deeper beyond merely the accounting numbers recited by the media and actually look at the income statement. For the quarter ended Dec. 28, 2013, Apple earned less money than it did in the year-ago period -- $13.072 billion versus $13.078 billion for the previous year's quarter.

So why were earnings per share higher when the company earned less? Because the number of outstanding shares was lower due to buybacks -- something Carl Icahn has been pounding the table for. 

A case against buybacks
Jeff Macke of Yahoo! Finance makes an incomplete case against buybacks, essentially stating that if share prices go down, the cash used for the purchase disappears and "goes to money heaven." Macke continues, pointing out that most managers don't have a proven track record of understanding when their stocks are cheap. He writes that in the year 2007, corporations bought their shares back in mass; as we all know, 2008 wasn't a great year for the market, adding that Apple more recently repurchased its shares at an average of $525. 

Counter argument
Aside from forgetting the possibility of share prices rising, Macke's arguments present only one side of the coin. A buyback reduces share count, thus giving existing shareholders a greater percentage of the corporation. If a company trades at a certain multiple to earnings per share, then the price of the stock will theoretically rise in accordance with the percentage of the float a company purchased and retired.
 
When a company issues a dividend, many investors, via their brokerages, automatically reinvest the payout into stock. This, of course, raises the number of shares they own in the company, and thus, their percentage. The downside of a cash dividend is that it is taxed, whereas a buyback, which achieves the same outcome, is tax-free.

Support from Buffett 
Warren Buffett refuses to issue a dividend, as he believes it is an inefficient use of capital, based squarely on the fact that investors must pay taxes on it.  
 
The Oracle of Omaha recently enacted his first ever buyback program for Berkshire Hathaway and has long been an advocate of them, advising none other than Steve Jobs, when Jobs remarked that he believed Apple shares were cheap, to go ahead and repurchase them. 
 
Why cash dividends matter
The one great thing about a cash dividend is you can be fairly sure that the corporation's CFO isn't gaming the numbers entirely. It's important to realize for some companies, there is a difference between "earnings" and being able to pay shareholders cash from them. Take it as a sign of financial health that will allow you to rest easier at night. 

Analyzing Apple today
Apple is a wonderful company that continues to make great products, but as competition stiffens in the smartphone and tablet market, Apple faces declining margins and pricing power.

Apple must innovate beyond its current product lines. On a recent CNBC appearance, former CEO John Sculley  suggested the most likely growth prospect for the company would be in mobile payments, given the fact that Apple's passbook application has 600 million registered users. Then there's the possibility of a wearable product (iWatch), and the long long rumored Apple TV which might excite consumers and investors alike, but without a doubt, Apple must introduce something new and novel in order to regain its former luster.  

Bottom line
All things equal, I would prefer a share buyback rather than a dividend I would have to pay taxes on. However, no matter how many shares a company buys back, it's likely to face a declining stock price when net income drops in the year over year quarter. That has nothing to do with a share buyback. I remain long on Apple. 

Margie Nemcick-Cruz owns shares of Apple. The Motley Fool recommends Apple and Berkshire Hathaway. The Motley Fool owns shares of Apple and Berkshire Hathaway. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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