International Business Machines (NYSE:IBM) has been the most outstanding underperformer of the market in the last 2 years. To be sure, while the market has advanced by 25%, IBM has declined by 5%. A strong pattern has been prominent, in which the stock price plunges after every earnings report and then it partially rebounds till the next earnings report, when it plunges even more. The main reason for the underperformance has been the 7% decline in revenue in the last 2 years. Even worse, the revenue is expected to fall another 0.5% this year, thus returning to its 4-year ago level.
The reason for the disappointing revenue is the fast-changing nature of the tech sector and the strategic decision of the company to sacrifice its now low-margin traditional segment (hardware) in favor of its high-margin segments, such as the business analytics and the cloud. The behavior of the stock reveals that the investor community is afraid that the transformation will not succeed and hence the future of the company is not bright. If the market did not believe this, the stock would not trade at a forward P/E of only 10.
The management on the other side has been doing its best to reward its shareholders by distributing 100% of its annual profit ($18 B) in dividends ($4 B, 2% yield) and share repurchases ($14 B for 2013). In this way, the company achieved 7% growth in its 2013 earnings per share (NYSEARCA:EPS) even though its net income grew only 2%. However, as the aggressive buybacks have not resulted in any capital gains for the shareholders in the last 2 years, the big question is whether the company should keep spending almost 80% of its net income in share buybacks.
In my opinion, the company should temporarily curtail the rate of its share repurchases. In this way, the stock price will (only) temporarily decline even further from its current levels because:
§ The company will not be purchasing about 7% of the average daily volume traded any more.
§ The EPS growth will temporarily decelerate.
Therefore, the future buybacks will be executed at even lower prices and hence they will be much more efficient than now.
Even better, the reduction of the buyback program will lead to the accumulation of excessive cash hoard, which will constitute a great defensive weapon for the management and the stock. As the investors will know that the company has excessive cash in its assets, they will hesitate to drive the stock price much lower because they will know that the company can initiate an aggressive buyback program any time, thus sending them to the wrong side of the trade.
It is also important to realize that the existence of a great cash pile will greatly protect the stock price in the event that the business greatly deteriorates. At the moment, if the business deteriorates, the stock will suffer a free-fall. On the other hand, if the company has a cash pile, the stock will not collapse because the management will aggressively purchase its shares at a much lower price. Therefore, the company should reduce its share repurchases until it makes sure that its transformation has succeeded.
To put it in another way, by growing its cash pile, the management will create a free put option for itself, just like the expensive options that are traded in the markets. More simply, the company will create its own insurance, which will protect the stock from a collapse whenever the business deteriorates, which is always a possibility in the fast-changing tech sector. Then, depending on the conditions of the business and the stock price, the astute management will exercise its option in the most efficient way for its long-term shareholders.
This is exactly what Apple (NASDAQ:AAPL) did, though I am not sure that the management did it intentionally. While the management of Apple was focusing only on the next great innovation with no interest in its shareholder distributions, the company accumulated a cash hoard of about $250 B. Then, about a year ago, when the stock price plunged by 40% off its all-time highs, the management initiated a buyback program, which has placed a solid floor for the stock price since then. The company has purchased fewer than 10% of its shares so far but it still has $187 B in cash, which reassures investors that the company can easily protect its stock price only with the use of its cash. It is only the existence of this amount of cash and a moderate buyback program that set a solid floor for the stock price; the company does not need to have an aggressive buyback program in use to defend its stock price.
Therefore, to sum up the concept, the management of IBM should temporarily reduce the buyback rate, thus leading its stock price lower in the short term, and resume its aggressive buyback program in the future, at lower prices, in which the program will be much more efficient. In the meantime, the cash hoard will always be providing a very solid floor for the stock price in the event that the business greatly deteriorates, which is always a possibility in the innovation-driven tech sector. It should be noted that this strategy will reward only the mid-term and long-term shareholders at the expense of short-term traders but every management should seek to reward only these types of investors.
Disclosure: I am long IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.