IBM (NYSE:IBM) returns significant amounts of cash to shareholders through dividends, but the majority of the company's cash allocation is spent on buybacks. In fact, IBM stated in its 2013 annual report, from 2000-2013, the company spent $170 billion on dividends, share buybacks, capital expenditures, and acquisitions. Of this, $108 billion was used for share buybacks. Here's why this massive buyback makes sense.
The road map to $20 per share
IBM maintains an optimistic long-term earnings forecast and the company expects to earn $20 per share in operating profit in 2015. This might seem ridiculous, given IBM's operating challenges in recent years but the key piece of the puzzle is IBM's share buyback program. The company's billions of dollars spent each year repurchasing stock is critical for meeting earnings projections. That's why IBM's share buybacks are a wise allocation of cash flow by management, because the company hasn't generated much revenue growth over the past several quarters.
The buybacks are helping bolster earnings per share as the company is struggling to grow revenue. Over the first half of the year, IBM's revenue was actually down 3%. Earnings per share, though, rose 13.5%, and share buybacks had a lot to do with that. This has effectively reduced IBM's share count over the past decade, which has helped produce most of its earnings growth. For example, at the end of 2013, IBM reported just over 1 billion common shares outstanding. Ten years prior, IBM had 1.7 billion shares outstanding. That means that IBM has reduced its share count by 700 million shares, or about 41%, in the past decade.
In the same ten years, IBM's revenue has grown just 12%. Meanwhile, earnings per share has more than tripled. Clearly, IBM's buybacks have done the heavy lifting to produce earnings growth. This reflects the value creation of IBM's aggressive share buybacks.
While IBM's turnaround materializes, management is aggressively buying back shares. Through the first six months of 2014, IBM spent $11.8 billion on share buybacks, up from $6.1 billion in the same period last year. This might seem like a strain on IBM's financial position given its sluggish operating results, but the company has a comfortable cash balance available for use: $9.7 billion in cash and marketable securities, down from $11 billion at the same point last year.
IBM's aggressive share repurchases are a wise decision, because they are more valuable thanks to the modest stock valuation. Investors haven't been too convinced in IBM's progress: The stock trades for $190 per share, which values the stock at just 11 times trailing earnings per share. In this environment, every dollar spent on repurchasing and retiring shares goes further when the stock holds a cheaper valuation.
IBM's aggressive buybacks are creating a lot more value for investors when the stock trades at a cheap valuation, rather than if the stock were expensive on a valuation basis. That's because each dollar buys more shares when the valuation is low, and more effectively reduces share count. Each remaining share then enjoys a larger slice of the company's earnings.
IBM is in an enviable position
While such a huge allocation to share repurchases might leave investors concerned there won't be enough cash to finance strategic growth initiatives, IBM is actually such a prodigious cash generator that it can accomplish each of its goals. IBM is growing in several new areas that will fuel future growth, particularly in cloud-based services. Cloud revenue soared more than 50% last quarter, year over year. For cloud delivered as a service, revenue nearly doubled in the last quarter to a $2.8 billion annual run rate.
In addition, IBM grew business analytics revenue by 7% through the first six months, and mobile revenue more than doubled through the first half of the year. Moreover, security revenue is up more than 20% over the first half of the year.
The combination of its investments in new areas and continued share buybacks while the stock is cheap leads management to believe it can still reach $20 per share in operating EPS by next year. IBM management expects operating earnings per share to reach at least $18 per share this year, so it only has to grow that number by 11% in 2015 to reach $20 per share. Considering IBM's earnings growth over the first half of this year, that is a realistic scenario. As a result, it appears IBM is effectively using cash flow to reward shareholders with its aggressive share buyback policy.
Bob Ciura has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. 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.