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The Real Game-Changer for Apple in 2014

By Andrés Cardenal – Feb 10, 2014 at 10:43PM

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Apple is doing the right thing by accelerating its stock buyback, but product innovation could be the real game-changer for the company in 2014.

Apple (AAPL -2.63%) is putting its abundant financial resources to use lately. The company has repurchased a whopping $14 billion of its own stock in only two weeks, with a positive reaction among many investors. Opportunistic buybacks are the smart thing to do in terms of capital allocation, but the real game-changer for the company would be successful product innovation.

Show me the money!
Renowned activist investor Carl Icahn announced on Monday his decision to back away from his nonbinding proposal that Apple increase its stock buybacks to $50 billion. The news comes after CEO Tim Cook said last week that the company repurchased nearly $14 billion in the two weeks following its latest earnings report, bringing the total buyback amount to more than $40 billion over the past year, so the company is aggressively putting its money to work.

Returning capital to shareholders is the right thing to do, considering that Apple has more than enough money to reinvest in the business and the stock looks materially undervalued at current levels.

With nearly $159 billion in cash and equivalents on its balance sheet, and generating over $22.6 billion in operating cash flow during the last quarter alone, there is no reason Apple should let all that money accumulate in the bank, generating lackluster returns, when it could be allocated much more efficiently by being distributed to shareholders.

The stock is also trading at a P/E ratio near 13 times earnings, a material discount to the average valuation of around 18 for companies in the S&P 500 index. Considering that Apple owns one of the most valuable brands in the world, a rock-solid balance sheet, and an extraordinarily profitable business, this entry price could easily be considered a buying opportunity for long-term investors.

When a company is repurchasing its own shares at a convenient price, it's not only reducing the share count and increasing earnings per share, but it's also putting the company's cash to work in a profitable investment. This is a double benefit for investors, so Cook is being a smart capital allocator by accelerating buybacks while the stock is attractively valued.

Show me the products!
Icahn recently compared via Twitter the valuation multiples the market currently assigns to Apple and Google (GOOGL -1.45%), and he reached the conclusion that Apple could trade near $1,245 per share if it carried the same valuation multiple as Google in terms of operating profit.

Google is growing considerably faster than Apple. Tthe search giant announced a sales increase of 17% for the December quarter, while Apple's revenues grew by 6.3% during the same period. Google arguably deserves a valuation premium over Apple, but the numbers still show that Apple has plenty of upside potential from current levels if the company can reinvigorate growth. 

To put things in perspective, Apple is trading at a similar valuation to Microsoft (MSFT -2.31%), which carries a P/E ratio of 13.6. However, Apple is a leading player in the mobile revolution thanks to the popularity of its iPhone and iPad products, while Microsoft has missed many of the most relevant trends in the tech industry in recent years, and the company is now trying to turn things around under the leadership its new CEO, Satya Nadella.

The market seems to be excessively pessimistic when it comes to Apple, and that's probably related to concerns regarding the company's ability to innovate without Steve Jobs. Cook has repeatedly said that the company will be entering new product categories in 2014, and this could be a real game-changer for the company during the current year.

Apple needs to prove that it can still create new and innovative products, not only because of short-term financial considerations, but, more importantly, because that would show that the company still has the talent and vision to think outside the box and operate like a disruptive growth player.

Bottom line
Apple is doing the right thing by accelerating its stock buyback at opportunistic price levels, and downside risk seems limited considering the stock's undemanding valuation. However, for Apple to move substantially higher, the company needs to prove it can continue innovating and disrupting. Buying stock back is a smart move, but innovation and disruption are what have made Apple one of the best companies in the world. 

Andrés Cardenal owns shares of Apple and Google. The Motley Fool recommends Apple and Google and owns shares of Apple, Google, and Microsoft. We Fools don't 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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