Activist investor Carl Icahn has been pushing Apple to greatly increase its share-buyback program. While Apple has spent nearly $26 billion over the past 12 months on its own shares, the company's enormous $150 billion pile of cash is just sitting on the balance sheet, earning very little. Along with annual free cash flow in excess of $40 billion, Apple seems to be generating more money than it knows what to do with. But will a massive buyback actually create value for shareholders? Or should Apple continue to maintain a massive war chest instead?

When are buybacks a good idea?
There are two conditions that need to be met for a buyback program to make sense. First, the shares of the company need to be undervalued. There are plenty of cases where companies spend huge amounts of money on buybacks during times when the stock price is high, only to reduce these buybacks when the stock falls into value territory. I would wager that a majority of buyback programs are ultimately destroying more shareholder value than they're creating, with a minority of companies strategically buying back shares when the price is right.

Warren Buffett's Berkshire Hathaway is a great example of a buyback program done right. Buffett uses the company's book value as a rough estimate of intrinsic value, and he buys back shares only when the stock price falls below 120% of the book value. As Buffett stated in his 2011 letter to shareholders:

Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation -- whether the money is slated for acquisitions or share repurchases -- is that what is smart at one price is dumb at another.


Buying only when the shares are undervalued ensures that the company achieves an adequate return on its investment. The company also needs to have ample available capital after all necessary expenses. Those companies that leverage the balance sheet in order to fund stock buybacks, risking the financial integrity of the company in order to boost the stock price, are doing shareholders a disservice.

Does Apple meet these conditions?
Apple seems to pass the second condition with flying colors, as the company is bursting at the seams with cash. One problem, however, is that much of this cash is held overseas. This cash would be subject to corporate taxes if brought into the United States, so its essentially off limits for the purposes of share buybacks and dividends. This leaves the amount of cash currently held in the United States, as well as the free cash flow derived domestically, as fuel for the buyback program.

And as Apple pointed out, since it first started its buyback program, the company has used all of its domestic cash flow -- and the proceeds from its debt offerings -- for dividends, buybacks, and investments back into the company.

Apple's buyback program can't be boosted unless the company either takes on more debt, which bumps up against the second condition, or it brings overseas cash back into the United States, in which case the tax paid would likely undo any benefit derived from the buyback program. While Apple pays a very low interest rate on its debt, debt-funded buybacks are generally a bad idea in the long run, serving to temporarily boost the share price instead of creating any long-term value.

The first condition is a little tricky. As I pointed out in a previous article about Apple's recent earnings report, the P/E ratio after backing out the net cash on the balance sheet is right around 8. That seems inexpensive, but Apple is having trouble growing its net income. While its per-share profit grew last quarter, its net income was basically flat, even with an increase in iPhone and iPad sales. A P/E ratio of 8 can still be attractive in a no-growth scenario, with per-share numbers boosted by buybacks, but if the current earnings level isn't sustainable, then Apple isn't very cheap at all.

With the iPhone and iPad making up more than three-quarters of Apple's revenue, and with increasing unit volume failing to grow net income, it's clear that Apple needs a new product in order to drive growth going forward. CEO Tim Cook has suggested that Apple has big plans for 2014, but whether Apple can repeat its game-changing iPhone and iPad successes is the billion-dollar question.

The bottom line
Apple can't increase its buyback program without taking on more debt, since most of its cash is held overseas. While it might be good for a temporary boost in the stock price, it likely won't create much value in the long run. Icahn doesn't own enough of Apple to put too much pressure on the company, and Cook's reluctance to give in to the demand is the right move. Whether Apple is truly undervalued today depends on whether it can continue to innovate and create new product categories. It looks like 2014 will be the year that investors finally get the answer to that question.

The next big trend in tech is here, and you can profit
If you thought the iPod, the iPhone, and the iPad were amazing, just wait until you see this. One hundred of Apple's top engineers are busy building one in a secret lab. And an ABI Research report predicts 485 million of them could be sold over the next decade. But you can invest in it right now... for just a fraction of the price of AAPL stock. Click here to get the full story in this eye-opening new report.

The article Should Apple Really Boost Its Buyback? originally appeared on Fool.com.

Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Apple and Berkshire Hathaway. The Motley Fool owns shares of Apple and Berkshire Hathaway. 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.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Portfolio Basics

What are stocks? Learn how to start investing.

View Course »

Professional Vs Do it Yourself Investing

Should you get advice or DYI?

View Course »

Add a Comment

*0 / 3000 Character Maximum