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Was Alphabet Inc.'s $5 Billion Buyback Justified?

By Leo Sun - Oct 29, 2015 at 4:00PM

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Wall Street loves Alphabet’s big buyback, but should all investors cheer?

Google parent company Alphabet ( GOOG 2.61% ) ( GOOGL 2.53% ) recently announced its first stock buyback program. The company will spend up to $5.1 billion on the program, which would be enough to buy back 1% of its nonvoting Class C shares at current prices.

Alphabet finished last quarter with $72.8 billion in cash, cash equivalents, and marketable securities and just $5.2 billion in debt. Nearly 60% of Alphabet's cash is overseas and can't be used for buybacks without being taxed, but the company still has enough domestic cash left to buy back shares without taking on new debt. While many analysts and investors praised the buyback as a long overdue move, let's step back and discuss the pros and cons of the decision.

Source: Pixabay.

Why a buyback makes sense
In the past, Google was often criticized for taking its shareholders for granted. The company's three-class voting structure made it impossible for even large shareholders to oppose the company's decisions. Its privileged Class B shares, reserved for top insiders, carry 10 times the voting power of regular Class A shares. Class C shares, which are usually granted to regular employees, have no voting rights.

Many investors also complained about Google spending billions on "moonshots" like driverless cars instead of rewarding patient investors with dividends or buybacks. Apple's ( AAPL 2.78% ) introduction of both programs in 2012 caused many analysts to suggest that Google do the same.

That's why Alphabet's new CFO, Ruth Porat, introduced the company's first buyback. The company's free cash flow of $14.6 billion over the past 12 months easily supports it, current investors will be happier, and valuations will slightly tighten up.

Why a buyback doesn't make sense
Those benefits seem solid, but there are a few drawbacks. First, Alphabet could accidentally buy back its shares at a premium. The stock certainly isn't cheap at 31 times trailing earnings, compared to a P/E of 23 for the NASDAQ 100. In hindsight, a better time to launch a buyback was last year, when the stock was weighed down by growth concerns.

Mature tech companies have been known to prioritize buybacks over acquisitions. IBM ( IBM 1.23% ), for example, once made a misguided promise to double its annual EPS between 2009 and 2015. To do so, IBM financed buybacks with debt, dumped lower margin businesses, and didn't acquire enough higher-growth businesses. Current CEO Ginni Rometty is still trying to undo that damage by reducing buybacks and boosting long-term investments. Alphabet might be lured down the same path, neglecting sleeper "moon shots" to boost buybacks and earnings per share.

Alphabet isn't oblivious to these concerns. In its press release, Alphabet said that it will repurchase shares "from time to time" based on "general business and market conditions" as well as "other investment opportunities." Porat promised that buybacks won't interfere with M&A, but that future acquisitions had to be big and smart.

Would dividends be better?
While buybacks can tighten up valuations and boost earnings, they sometimes benefit companies more than shareholders because they also offset dilution from stock-based compensation. That's why I personally prefer dividends over buybacks. I discussed this problem in an article last year, after several analysts urged Google to follow Apple's lead by introducing a dividend.

But as Alphabet clearly states on its investor website, it doesn't "expect to pay any cash dividends in the foreseeable future." The reason is simple: Quarterly dividend payments can throttle its ability to make big acquisitions or invest in new technologies. Buyback plans, however, are more flexible and can be adjusted based on M&A needs.

The verdict
All things considered, Alphabet's $5 billion buyback was the right move. It can be easily sustained by Alphabet's current cash flow and demonstrates a new willingness to enhance shareholder value. But if Alphabet's core advertising growth engine slows down in the future, investors should see if the company starts relying too heavily on buybacks to lower its share count or inflate its earnings.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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