By David Sterman
As many companies prepared to disclose second-quarter earnings, they noted a fundamental disconnect between their outlooks, their balance sheets and their lagging share price. In search of a remedy, these companies announced major stock buyback programs. Little did they know the stock market plunge of the past two weeks would make their shares even cheaper. Well, they can at least take solace in the fact that a lower share price means they can buy back even more stock than they originally envisioned. In many instances, companies are buying back 5% or even 10% of their stock, reducing the denominator (number of shares outstanding) by an equivalent amount in earnings per share calculations.
Of course, a stock buyback shouldn't merely be to impress investors. When Visa (NYSE:V) announced a buyback plan on July 27 that would shrink the share count by just 2%, investors had every right to yawn. Yet you should take note of the companies in this table, all of which announced buyback plans of at least $1 billion, and all of which promise to reduce the share count by at least 5% if the plan is completed at recent prices.
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Some companies don't have much choice other than to buy back their own stock. They are sitting on lots of cash, with minimal near-term growth prospects. Defense contractor Harris Corp. (NYSE:HRS) might as well radically shrink its share count while defense budgets weaken. Its shares have plunged so far that they now sport super-low price-to-earnings (P/E) ratios. The board at Hewlett-Packard (NYSE:HPQ) has likely concluded that it's wiser to invest in its own stock -- to the tune of $10 billion -- rather than seek acquisitions that may not pay off in an uncertain economy.
A number of smaller companies are also getting into the buyback game. As I noted in this recent article, Coinstar (CSTR) is now generating ample cash flow and can afford to take advantage of a 40% drop in its stock from the 52-week high. Reducing the share count by up to 20%, while shares trade for well less than the earnings growth rate, makes ample sense.
In a similar vein, Southwest Airlines (NYSE:LUV), with its shares trading right back where they were 15 years ago, is applying all of its free cash flow into buybacks. I still think Delta Airlines (NYSE:DAL) is a top holding for those willing to ride out the sector, but Southwest also looks like a safe place to be if rivals take a deep hit from an economic downturn. Bad news for weaker carriers, which would need to shrink or go out of business, would be good news for Delta and Southwest.
With shares in the midst of a deep slump, Akamai (NASDAQ:AKAM) announced on July 27 that it would buy back up to $250 million in stock. Thanks to this week's market rout, shares have fallen even further, leading management to expand the buyback to $400 million. This promises to shrink the share count by up to 10%.
Akamai is the leading operator of content delivery networks (CDN), which are networks of servers housed in many cities that deliver web content to local users very quickly. Recently, it's been a pretty lousy business because increasing competition has led to price wars for CDN services. Second quarter traffic on Akamai's CDN rose more than 25%, but price concessions led to sales growth of just 13%. This was below forecasts, and analysts quickly lowered their estimates for the third and fourth quarter.
Yet behind the headline numbers, a promising transition is underway. Investors have historically thought of Akamai as a company that delivers video streaming services for firms like Netflix (NASDAQ:NFLX). This is precisely the part of the business that is being commoditized and subjected to price wars. Yet Akamai is increasingly moving upstream, using its servers to handle higher-margin services such as e-commerce web sites and other "cloud-computing tasks."
To be sure, Akamai is facing headwinds that dampening Internet traffic growth and causing an enterprise adoption of the company's value-added services to slow, according to analysts at Dougherty & Co. Yet as those headwinds abate, the higher-margin value-added services segment should continue to post impressive growth rates, as had been the case throughout much of 2010. This is why Dougherty still sees shares rebounding to $36, more than 50% above current levels.
Analysts at Merriman take a more somber view and think shares don't deserve to trade at a premium to the peer group anymore. But they also predict shares will rebound back to the mid-$30s once investors come to see the entire industry is still poised for steady growth as cloud computing becomes even more entrenched in 2012.
This former highflyer often traded for 30 to 40 times earnings but now trades for less than 14 times projected 2012 profits. Back out the company's $1.28 billion in cash and that forward multiple falls closer to 11. The share buyback will impact cash, offset by the fact that Akamai generates more than $100 million in cash flow per quarter.
The buyback boom isn't over. If the stock market remains under pressure, then look for more buyback announcements in coming weeks and months. In a quarter or two, you'll start to notice rapidly falling share counts. Indeed, this market downdraft does have a silver lining for companies looking to use their strong balance sheets in this time of distress. And these are exactly the type of stocks you want to own in times like these.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.