A Stock Buyback Would be a Smart Catalyst for Apple

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A big part of the discussion surrounding Apple (NASDAQ: AAPL) seems to be focused on the lack of a catalysts for appreciation in the middle term. The stock has received a big flow of negative coverage from Wall Street analysts over the last months, and it could certainly use some positive news to change the market´s perception.

 A share buyback could be a fantastic catalyst, and it also makes a lot of sense from the point of view of value maximization and capital allocation.

A Healthy Repurchase

If there is someone who understands smart capital allocation, that would be Warren Buffett, arguably the best investor ever alive. He has been thinking a lot a about buybacks lately, and Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) even repurchased a small amount of stock for the first time in history back in 2011, and a bigger amount from a long time shareholder a few weeks ago.

Why did Buffett decide to repurchase stock? We can get a clear idea from Berkshire's shareholder letter for 2011:

Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.

The two conditions, sufficient financial resources and an attractive valuation for the stock, are quite intuitive and easy to understand. But another important aspect to keep in mind is that share repurchases increase shareholders' returns if they are done under the right circumstances.

In the same letter to investors, Buffett explains his rationale for taking a big position in IBM (NYSE: IBM). Not only has the company remarkably improved its operations over the last years, an outstanding share repurchase policy has been another strong reason behind Buffett's decision to invest in IBM.

Let’s use IBM as an example. As all business observers know, CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary.

But their financial management was equally brilliant, particularly in recent years as the company’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.

Buffett then explains that these kinds of repurchases add value for shareholders in the long term, because the company is wisely allocating its capital towards a convenient investment, its own stock.  In fact, the Oracle of Omaha is quite upbeat about IBM's share repurchase programs.

In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million, I will abandon my famed frugality and give Berkshire employees a paid holiday.

Financially Strong and Undervalued

Analyzing Buffett's recommendations for a good buyback candidate, Apple fits that description pretty well, both in terms of having enough financial resources and a convenient valuation.

The Cupertino giant has more than $120 billion in cash and liquid investments on its balance sheet, and the company generates tons of free cash flows on a quarterly basis, so financial strength is unquestionable in Apple's case. In fact, the company's cash balance covers around 25% of its market cap; that's a lot of money earnings almost zero returns when it could be much better used in buying back the company's shares.

Besides, the stock is almost ridiculously cheap. The company trades at a P/E ratio of 11.5, which is exceptionally low by historical standards for Apple, and also in comparison to other big technology players.

In fact, Apple is cheaper than Microsoft (NASDAQ: MSFT), which carries a P/E of 14.5, and this doesn't make any sense at all considering current industry trends and future growth possibilities. Apple's success in mobile has clearly hurt Microsoft over the last years, and Apple has even gained market share with Mac versus Windows PCs.  

Microsoft is trying to turn things around with its new Windows 8 and Surface tablets, but it's not off to an auspicious start so far. Apple is strongly positioned to outgrow Microsoft over the next year, yet the stock is materially cheaper.

Bottom Line

Apple has too much cash on its balance sheet, and the stock is seriously undervalued, a combination which merits a stock repurchase. This could provide a much awaited catalyst for the stock in the middle term and, more importantly, it represents a smart capital allocation decision from a long term perspective.

acardenal owns shares of Apple, IBM, and Berkshire Hathaway. The Motley Fool owns shares of Apple, Berkshire Hathaway, International Business Machines, and Microsoft. Motley Fool newsletter services recommend Apple, Berkshire Hathaway, International Business Machines, and Microsoft. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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