Buybacks Aren’t The Problem For Apple Inc.

Is Apple Inc. (NASDAQ:AAPL) undervalued?

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This article originally appeared on Fool.com

WASHINGTON, DC — Apple, (NASDAQ: AAPL.US) stock fell nearly 10% following its earnings report last week, leading many to speculate on what went wrong. In some sense, nothing really went wrong: Apple had record iPhone and iPad sales, and Apple’s record EPS of $14.50 beat the average analyst estimate.

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Nevertheless, in the search for a scapegoat, Jeff Macke of Yahoo! Finance’s Breakout is pointing the finger at Apple’s buyback program. In a commentary with the blaring headline, “Apple slammed! Why buybacks Are for iDiots,” Macke claims that buybacks don’t have any tangible benefits — and that Apple is therefore wasting shareholders’ money.

Are Apple’s big share buybacks a waste of money?

This allegation is wrong-headed. It’s true that buybacks aren’t a cure-all for stagnant or declining businesses. If you think Apple is either one of those, than you shouldn’t be investing in Apple stock just for the sake of buybacks. However, if Apple returns to growth later this year — as I expect — its ongoing buybacks will have created substantial value for shareholders.

EPS vs net income

While I don’t agree with Macke’s full analysis, he makes a valid point that the media’s singular focus on earnings per share as opposed to net income can be misleading. In fact, while Apple’s EPS hit a December quarter record, the company’s December quarter net income has not budged in the last two years.

In other words, Apple’s EPS growth last quarter did not represent organic earnings growth: It was driven by share buybacks. EPS is calculated as (Net Income/Shares Outstanding). By reducing the number of shares outstanding — which is the denominator of the EPS equation — Apple was able to boost EPS without actually growing earnings.

EPS still matters

It’s true that buying back shares can’t boost net income. In fact, in Apple’s case, the share repurchase program is hurting net income, because the company sold bonds in order to buy back shares. The interest expense for those bonds reduces net income.

However, while investors shouldn’t focus solely on EPS and ignore net income, it would be equally wrong to focus solely on net income while ignoring EPS! By reducing the share count, share buybacks give each remaining shareholder a larger ownership position of the entire company.

A year ago, when Apple was dividing up its earnings among each share (i.e. calculating EPS) it had to split each dollar of earnings among nearly 950 million shares. Today, it only has to split that dollar among 900 million shares. That means each share is getting over 5% more of the company’s profit.

The value of buybacks

A few years before his death, Steve Jobs asked legendary investor Warren Buffett for advice about what to do with Apple’s growing cash stockpile. Buffett told Jobs that if Apple stock was undervalued, the best option would be to buy back shares. Share buybacks add value for long-term investors in an undervalued company, as they will own a greater percentage of the company when the market finally catches on to its true intrinsic value.

Following Apple’s recent stock slide, its shares sell for a little more than 12 times trailing earnings. That’s significantly below the average for public companies in the U.S. Unless Apple has worse growth prospects than the average company out there, its stock must be undervalued — making this an ideal time for Apple to buy back even more shares.

Apple spends more on R&D each quarter today than it did in the two years before it introduced the iPhone (Photo: Apple)

It’s certainly possible that Apple has peaked, but it doesn’t seem very likely. Apple bears who claim that buybacks are a sign that innovation is dead at Apple miss the fact that Apple is spending an ever growing amount on R&D. In 2005 and 2006 — when Apple was developing the iPhone — Apple spent a 2-year total of $1.25 billion on R&D . By contrast, Apple spent a whopping $1.33 billion on R&D last quarter alone!

This suggests that there are plenty of new products and services in the pipeline at Apple for the next few years. Beyond that big hint, Apple CEO Tim Cook has repeatedly stated that Apple will be entering one or more new product categories this year. Moreover, there are growth opportunities left within Apple’s existing product lines, such as the recent agreement to bring the iPhone to China Mobile.

Foolish bottom line

If Apple’s net income never budges from where it sits today, than share buybacks alone are not going to generate much EPS growth. However, if Apple is getting any value at all from its $5 billion annual R&D budget, the company should be able to resume organic earnings growth by releasing new products (and to a lesser extent, riding the wave of growth in global smartphone and tablet sales).

Share buybacks aren’t the reason why Apple stock has lost its momentum — but they could be the solution. Apple stock has fallen to a level that implies its has no growth prospects whatsoever. However, if a return to growth is on the horizon, the best thing Apple’s management can do today is to buy back more stock. (That would be much better than rushing a half-baked new product to market, for example.)

Shrinking the share count now will accentuate the impact of organic earnings growth on Apple’s earnings per share next year and beyond. If you are a long-term Apple investor, presumably you believe that the stock is undervalued. If that’s true, bigger buybacks today will create even bigger upside tomorrow for Apple stock.

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