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Wednesday, November 13, 2013 - 08:30
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Wednesday, November 13, 2013 - 08:30

2 Stocks To Capitalize On The Buyback Boom

Wednesday, November 13, 2013 - 8:30am

A steady scan of the financial headlines these days implies that it's the golden era of dividend investing.

But it's not true.

Though many companies are boosting their dividends at a solid pace, dividend yields remain far below the levels seen back in the 1970s. Back then, companies earmarked the vast majority of their profits for dividends. Today, payout ratios usually hover below 35%.

If one investment theme is surely at a high point, it's stock buybacks. As I noted two months ago, companies have bought back more than $1 trillion since 2009, and the pace of buyback activity has actually grown stronger in 2012 and 2013.

The timing is curious. The market has posted impressive gains since bottoming out more than four years ago, and many stocks are trading near all-time highs. In the past, companies would only pursue large stock buybacks when their shares were in the doghouse.

Still, it's worth tracking any buybacks plans that promise to retire 10% or even 15% of the current share count. And in the current earnings season, we've seen a fresh batch of hefty plans that fulfill that mandate. Here are a dozen companies, each sporting a market value of at least $1 billion, which have a chance to make a meaningful dent in their share counts.

Though these plans may seem impressive, you need to dig a little deeper to see if the plan makes strategic sense. As an example, Electronics for Imaging (Nasdaq: EFII), a leading provider of high-end printing equipment, has seen its shares more than double this year, and rise nearly 300% over the past five years. With shares trading for more than 20 times projected 2014 profits, and top-line growth expected to slow next year into the mid-single digits, it's hard to see why a new $200 million buyback plan was put into place.

This is a very cyclical business, and a buyback like that would be a lot more effective at a cyclical low.

For that matter, when you see companies like Microsoft (Nasdaq: MSFT) announce plans to buy back more than $10 billion in stock, you need to wonder why the software giant ignored calls for a big buyback a few years ago when its shares hovered in the mid-$20s. Now that shares are approaching nearly $40, the timing for a buyback appears off.

Yet several companies in this group, after further research, appear to hold real appeal. They include:

1. Brocade Communications (Nasdaq: BRCD)
Brocade kicked off the buyback season a bit early, announcing in late September that a current $308 million plan would be expanded into a $1 billion plan. This network equipment maker is valued at less than $4 billion, meaning this buyback plan has real teeth.

Brocade's share count swelled to 497 million by the end of 2011 but is already down to 461 million, and could move below 350 million by the time this buyback program is complete. Brocade has less than $200 million in net cash, though the company is expected to generate more than $500 million in free cash flow in both 2014 and 2015, according to consensus forecasts.

The buyback could be seen as an effort to beat back a perception problem: As I noted in late September, the networking equipment sector is on the cusp of a major shift toward software defined networking (SDN), and Cisco Systems (Nasdaq: CSCO) has grabbed the bulk of mindshare on this trend thus far. Yet at its annual analyst/investor day in late September, Brocade focused a great deal of time on its own SDN strategies.

2. Travelers (NYSE: TRV)
This property and casualty insurer, which is one of the smallest members of the Dow Jones Industrial Average, is the poster child for buybacks. In recent years, the sharer count has been dropping at a fast pace.

Travelers' Shrinking Share Count

Remarkably, this trend shows no signs of letting up. Travelers had $759 million left on a previous unfinished buyback plan at the end of the third quarter and recently added another $5 billion to the pot. That $5.8 billion buyback would retire 65 million shares at current prices, dropping the share count to 300 million.

And you can see the impact of a smaller share count on earnings per share (EPS), which are likely to reach almost $9 this year, handily topping the record $6.85 a share earned back in 2007. Back then, when interest rates were higher, Travelers' operating profits peaked at $6.2 billion. In comparison, they're unlikely to reach $4 billion this year. So when interest rates normalize and operating profit moves back up to prior peaks, the far smaller share count will translate into far better earnings power, with EPS perhaps approaching $12 to $13 a share.

Risks to Consider: Buybacks are best completed with available cash on hand. Some companies seek to borrow funds to pursue buybacks, which can lead to future trouble if the economy slumps and the debt load becomes troublesome.

Action to Take --> These buyback plans are enabling rapid gains in EPS, even as top-line growth remains more muted -- and they set the stage for record EPS when the economy is at full boil. Companies that are pursuing double-digit buybacks merit a closer look, to say the least.

P.S. Stocks like TRV are similar to a special group of securities we call "Forever" stocks. These are world-dominating companies that buy back massive amounts of stock, boosting the value for the rest of the shares. They're solid enough to buy, forget about and hold -- "Forever." To learn more about these stocks -- including some of their names and ticker symbols -- click here.

 

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.