Share buybacks are all the rage these days, and that's especially true when it comes to the technology sector. Many technology companies are spending billions of dollars buying back their own stock. Thanks to the steady economic recovery, technology companies such as EMC (NYSE:EMC) are seeing their coffers swell with cash. EMC has decided to use a lot of that cash flow to buy back its own stock.

Theoretically, this is a great use of cash. By buying back its own shares and retiring them, a company can increase earnings because each remaining share captures a higher portion of profits. When allocated properly, share buybacks can create significant value for shareholders.

However, every company has other needs for its cash flow, too. In addition to buying back its own stock, companies can use cash flow to pay dividends or invest back in the business to fuel future growth. The latter area is where EMC appears to be falling behind. The company spends much more on share buybacks than it does on capital expenditures. In the fast-paced world of technology, this is an ill-advised decision. EMC should maintain a more even balance between capital spending and share buybacks.

Are EMC's capital allocation priorities misguided?
Over the past 12 months, the company has bought back $3 billion worth of its own shares. So far this year, the company spent $994 million buying back its own stock. That's notable because the company spends far more on share repurchases than it does on other methods of capital allocation. For example, over the first half of the year, EMC paid just $407 million in dividends and spent $472 million on capital expenditures.

Dividends shouldn't be much cause for concern to shareholders. EMC is a technology company, and many companies in the tech sector pay little or no dividend. Plus, EMC provides a 1.6% dividend yield, which is a decent enough payout.

The primary concern investors should have is EMC's level of capital expenditures. . EMC's financial performance this year has been good, but far short of spectacular. For example, the company grew revenue by just 3% over the first two fiscal quarters. Operating profit has declined in this period, mostly because of higher selling, general, and administrative expenses.

Where investment is necessary
EMC has some clear areas for improvement, where it should focus investment going forward. One of these is its core storage business, where performance has been modest at best. EMC's information infrastructure unit posted just 1% revenue growth last quarter.

Within this business, EMC should focus on storage. It's seeing great results for its all-flash, software-defined, and scale-out storage. These are each emerging technologies that collectively generated 52% revenue growth last quarter, year over year. Specifically, EMC's all-flash product XtremIO is now at more than a $300 million annual run rate, and has compelling future potential, since it's only been available for two quarters.

A better balance is appropriate
As a result, it's reasonable to question how much money the company is spending on buying back its own shares, considering growth has been meager so far this year.

However, management doesn't plan to curtail its aggressive buyback policy going forward. After releasing second-quarter earnings, the company said it would accelerate share repurchases from $2 billion to $3 billion for the full year.

Management stated on the most recent quarterly conference call that the IT world was about to undergo a huge structural change, from the PC era to a technology world dominated by continuously connected mobile devices, cloud computing, and big data. In light of this shift, EMC management noted on the conference call the enormous strain on executives to make sure they're appropriately investing to capitalize on these trends.

Whether EMC is practicing what it preaches can be questioned, considering the amount of cash the company is spending on buybacks. On the same conference call, management said it had met with over 100 investors and heard a recurring criticism that the company's growth had slowed. In response, management is confident that the company has made large strategic investments that should pay off over the long term. Investors should pay close attention to how much growth the company produces over the next few quarters to make sure this isn't just lip service.

 

Bob Ciura has no position in any stocks mentioned. The Motley Fool owns shares of EMC. Try any of our Foolish newsletter services free for 30 days. 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.