2 Things That Really Matter For Apple's New Share Buyback Program

Mar.25.14 | About: Apple Inc. (AAPL)

Summary

Analysts and investors expect Apple to announce an extension of its share repurchases.

Apple's share repurchases with cash do not create value for the shareholders.

Share repurchases could only deliver value if Apple's shares are undervalued.

A new, large buyback program would be a clear signal by Apple's board.

Many analysts and investors expect Apple (NASDAQ:AAPL) to announce a new share buyback program soon. Apple's CEO Tim Cook fueled the expectations in his interview with The Wall Street Journal, saying that Apple repurchased $14 billion of its own shares in the two weeks past the release of Apple's first quarter earnings report. As a result, Apple already repurchased $40 billion of its $60 billion share repurchase program. It makes sense that this $60 billion program will come to an end faster than investors initially expected. In my opinion, Apple's decision whether to introduce a new buyback program or to stop repurchasing shares after the company completes its current program could be a major factor for the performance of Apple's shares this year. In this article, I will argue that two things really matter when it comes to a potential new buyback program: 1. the size of Apple's share repurchase program and 2. the board's arguments and conditions.

Share repurchases and value creation

Overall, I favor share repurchases in the case in which a company finances the repurchases with debt. In Apple's case, the company repurchases its own stock out of its huge cash pile. In theory, moving money from Apple's balance sheet to the pockets of its shareholders does not create any value at all. A decrease of the company's cash leads to a higher risk premium. An often heard argument is that the company's earnings per share increased. This is true. However, the repurchases did not create value for the shareholders because investors will demand a higher return for Apple's equity.

In a perfect world without taxes, share repurchases financed with debt do not create value for shareholders as well. In that case, the cost of capital changes and investors will demand a higher return on equity. As a result, equity becomes more expensive and the value of the company is unchanged (comparable to repurchases with own cash). However, we do not live in a perfect world and we have the "luxury" of paying taxes. Taxes change everything, because interest expenses are deductible expenses. So, the government finances a part of the company's share repurchases. This creates value for the shareholders and for this reason I favor share repurchases financed with debt over share repurchases financed with cash.

There is a second scenario in which share repurchases could create value for shareholders. However, this scenario is not as clear as the "tax benefits" I mentioned above. Share repurchases could serve as an important signal and commitment by a company's board. In this scenario, share repurchases could create value for shareholders due to an information advantage by the company's board. First of all, aggressive share repurchases indicate that the board is confident about the company's future. Second, the board sends a clear signal to the market that it finds the company's current share price undervalued. Otherwise, why should a company buy its own stock?

Apple's share repurchase program

Now, how does the theoretical approach impact Apple and its decision whether to introduce a new buyback program or stop when its current program expires? Despite that Apple issued long-term debt to finance just a part of its current $60 billion program, the company paid most of its repurchases out of its own cash pile. Therefore, the "tax benefit" argument does not apply to Apple. As a result, the repurchases did not fully create value for shareholders. What remains is the importance of the board's commitment to buy its own stock, given Apple's share price around $532 a share.

In my opinion, Apple's board gave a clear signal when it started its current share repurchase program. The company started to buy back its own stock aggressively, after the stock fell below $500 a share (see graph below). Further, Tim Cook stated in his interview with the Wall Street Journal that Apple bought back $14 billion of its own shares after the stock price decreased below $500 a share, following Apple's first quarter earnings report. This sends out a clear signal that Apple's board believes that the stock is undervalued. Overall, Apple increased its repurchase efforts when the stock started to show weakness and the company's valuation (for example its P/E ratio) declined sharply. I believe this is a value creation approach by Apple's Board.

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Back to Apple's upcoming decision whether to introduce a new program of share repurchases. If Apple's board announces not to extend its current program, this could have a massive impact on its stock price. Such an announcement signals weakness and will probably send the stock lower. However, I do not think it is likely. Why else would Apple bought back $14 billion of its own shares at $500? Apple's current share price trades around $532, not far of this $500 mark. Therefore, Apple is most likely to announce more repurchases soon and I will focus on to the size of Apple's new program. Obviously, a large program will be a more positive signal than a relatively small program.

Board's arguments for repurchasing shares

Since Apple finances most of its share repurchases with its own cash, the board's arguments that come with the potential announcement matter as well. I already concluded that share repurchases only make sense if the board believes that Apple's shares are undervalued. Otherwise, the announcement for a new program does not create value for shareholders and will have a neutral effect on the company's share price. Therefore, it is important to evaluate the board's arguments for the introduction of the new program.

Another important factor is the conditions for the buyback program. These conditions cover various aspects, for example the time frame, the execution etc. Generally, I prefer buyback programs over a longer period of time and with no restrictions for the company's board to make opportunistic purchases if the opportunity presents itself (as Apple did in the two weeks following its first quarter earnings report).

Companies often make the mistake to announce a share buyback program just because the market demands it. Let me be clear that Apple should not make the same mistake and announce a new buyback program because everybody expects Apple to announce such a program. However, I am confident that Apple's board will not make this mistake, since the company has been very tight with money in the past. Tim Cook's statements in his interview with the Wall Street Journal were very encouraging as well.

Conclusion

Apple repurchases shares out of its existing cash pile. Therefore, the company does not experience the potential tax benefits. To create value for its shareholders, investors should look for 1. the size of the buyback program and 2. the board's arguments and condition. In my opinion, the best scenario is a relatively large buyback program over a longer period of time. Further, Apple's board should have the freedom to make opportunistic purchases. I believe that this creates the most value for Apple's shareholders. If the company announces such a program, I have no doubt that Apple's share price will benefit in the long-run as well.

Disclosure: I am long AAPL. 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.