In spirit, a stock repurchase program is pretty straightforward. The idea is that for whatever reason, a publicly traded company decides that the best way to spend its money is on buying back stock instead of using it for, well, anything else. The shares are purchased on the open market and absorbed by the company, effectively increasing the value of the remaining outstanding stock.
But the problem with share repurchases is that like with any other equity transaction, you can unwittingly make a bad trade. For example, Dell Inc. famously botched its buyback strategy and over the course of many years wasted a huge amount of cash by purchasing shares at a high premium. Dell spent nearly every penny it earned buying back stock, transferring the wealth of its business — which it owed either to shareholders or to reinvestment — to speculators, swing traders, or anyone else invested in the company simply to make a quick buck and not for the long haul. The nearly $40-billion fiasco has become the gold standard for what not to do with a buyback program.
So in April, when Apple Inc. (NASDAQ:AAPL) announced that its board of directors had increased the company’s share repurchase authorization from $10 billion to $60 billion, the market summoned the zeitgeist of the Dell fiasco and asked the obvious question: Is this really the best way for Apple to deploy its cash? The authorization created the single largest buyback program in history, so its failure could have a significant impact on the company. On the other hand, its success could increase shareholder value and shake out short-term speculators from the stock, leaving a more attractive core of long-term investors.
Before digging in to whether Apple’s repurchase program has been effective, it’s worth hashing out exactly what makes any repurchase program effective. Perhaps unsurprisingly, Warren Buffett, chairman and CEO of Berkshire Hathaway Inc. (NYSE:BRKA)(NYSE:BRKB), has done a good job setting the parameters.
“There is only one combination of facts that makes it advisable for a company to repurchase its shares,” Buffett wrote in his 1999 letter to shareholders, responding to calls from Berkshire shareholders to implement a buyback program of his own. “First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated.”
In 2011, after about 40 years of shunning buybacks, the board of directors at Berkshire decided the time was finally right. The board authorized the company to repurchase Class A and Class B shares at a price up to a 10 percent premium on the book value of the shares (a premium which was later adjusted). True to his original logic, Buffett’s buyback program met the constraints he outlined 12 years earlier.
When the repurchase was announced, Berkshire had nearly $58 billion in cash, and shares were trading close to book value. The board stated that repurchases would not be made if Berkshire’s consolidated cash equivalent holdings fell below $20 billion. What’s more, the board said that the duration of the program was indefinite, and its members were in no way obligated to purchase any shares at all, if they chose.
“In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise,” the repurchase statement said. “If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.”
What Buffett did was clearly outline his buyback strategy and why he thought it was a good idea. This reassured investors that Berkshire would only spend money in a way that made sense. To a degree, Apple’s buyback program does the same thing. The release doesn’t reveal the specific constraints that Apple has in mind, but at a glance, CFO Peter Oppenheimer’s comments suggest that he has some in mind.
“We continue to generate cash in excess of our needs to operate the business, invest in our future, and maintain flexibility to take advantage of strategic opportunities,” he said in the announcement. As long as this is true, the repurchase satisfies the first of Buffett’s conditions for buybacks.
The company was unclear about any price constraints on the buyback, which is one reason why some investors are waggling their eyebrows at the program. However, it does look as though the company is exercising its authority to buy on the dip. Apple stock fell more than 8 percent after the company reported fiscal first-quarter earnings that were apparently not up to snuff. Without missing a beat, Apple — and Carl Icahn, of course — bought up everything that was for sale. Apple CEO Tim Cook revealed shortly after the earnings announcement that it put $14 billion of its share repurchase authorization to use to buy during the dip.
After just a few days, Apple’s stock price recovered from around $500 to more than $540. Assuming the price holds, Apple’s repurchase was well timed, effectively transferring $1.4 billion in regained paper wealth from those investors who sold in a fit of post-earnings skepticism to those who decided to hold on to the stock. A larger repurchase made in 2013 had a similar effect.
If Apple continues to purchase shares when they are relatively cheap, as it has done so far, the program will continue to be a boon for long-term investors.