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Friday, March 21, 2014 - 14:30
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Friday, March 21, 2014 - 14:30

This 'Hated' Stock Is A Buyback Champion

Friday, March 21, 2014 - 2:30pm

Though I tend to generally find the customer service at major companies to be lacking, I give high marks to satellite TV operator DirecTV (NYSE: DTV). The company charges me a lot of money every month, but backs it up with professional customer support and trouble-free service.

Yet DirecTV is facing a problem that many companies are experiencing: Growth is slowing, and the company is likely to add few new customers this year.

It's a good thing that management spent heavily to build up its service years ago and has few major new investments to make these days. That enables DirectTV to generate more than $2 billion free cash flow, year in and year out. Shareholders have directly benefited from the cash production. A look at earnings per share explains why, as I'll show in a moment.

Take a look at the company's key income statement metrics across the span of five years.

Since 2009, sales have grown nearly 50% (largely thanks to growth in Latin America), operating profits have risen 150% and net profits have nearly tripled. Yet the company's earnings per share have risen more than 400%. Credit goes to a rapidly shrinking share count, thanks directly to the company's prodigious free cash flow. In fact, DirecTV's share count has been on a diet for nearly a decade.

Shares Outstanding

Said another way, if DirecTV had kept shares outstanding constant at 2009 levels, 2013 earnings per share (EPS) would have been $2.88. Instead, the company earned more than $5 a share last year. Ongoing buybacks help explain why a company that is poised for just 5% sales growth in 2104, is on track to boost EPS at a low teens clip in 2014 and 2015.

DirecTV isn't alone. According to Citigroup (NYSE: C), 10 companies in the S&P 500 have managed to reduce their share count by more than 20% over the past five years.

Share Count Shrinker

These companies have been reducing shares outstanding at a steady pace each year, and most of them have current buybacks underway as well.

Two Shrinkers To Watch
You'll see some health and general insurers in the group. Both Aetna (NYSE: AET) and Wellpoint (NYSE: WLP) have historically been operating with way too much cash on hand, and they should pursue buybacks even more aggressively in coming years. Dow component Travelers, in keeping with other mainline insurers has been doing the same. Yet Travelers trades above tangible book value. The ideal insurer is one that trades below book value and is buying back stock. Several of them are, though my favorite remains AIG (NYSE: AIG), which has a market value of $73 billion yet tangible book value of $100 billion.

At the end of 2011, AIG had shares outstanding of 1.8 billion though that figure has since shrunk to 1.48 billion. A February buyback announcement shows an ongoing commitment to a lower number in the future. Trading at 73% of tangible book, AIG's buybacks are a no-brainer.

The Buybacker For The Years Ahead
AIG had a notorious brush with death in 2009, and still remains a bit tarnished in the eyes of investors, which explains the below book valuation. The same can be said for Citigroup, which is much healthier than a few years ago, but is still dogged by concerns about too much emerging market exposure, a scandal in Mexico and a too-high cost structure. Shares are down roughly 10% in the past two months.

Merrill Lynch's analysts just trimmed its near-term profit outlook for Citigroup (NYSE: C), citing several headwinds. Yet they add an important, overlooked point: "It is hard to ignore a stock trading below $50, when TBV (tangible book value)/share will end this year at $60 -- even after the estimate cuts." They add that "once the market have been convinced estimates have bottomed and C lays out a more convincing path towards achieving its mid-term goals, a re-rate to TBV can happen quite quickly -- and we've seen this happen at other large financials, who are now trading at or above TBV even before reaching 10% tangible ROE (return on equity)."

The cure for this lagging stock is simple. With shares trading at a 15% discount to current tangible book value, which is itself rising at a nice pace, Citigroup needs to catch the buyback fever. Merrill's analysts think the dividend will get some attention, forecasting it will rise from $0.27 a share this year to $1 a share next year, but that still leaves ample cash flow for buybacks.

As soon as next week, the Federal Reserve may tell Citigroup if it can start buying back stock. If Citigroup gets the red light again this time around, a green light in the next go-around appears quite likely.

Risks to Consider: Both AIG and Citigroup are still fixing broken operations and might have a few more challenging quarters ahead of them, making these more suitable as long-term investments rather than short-term trades.

Action to Take --> It's hard to overstate that impact that share buybacks have had on this bull market. Not only do buybacks boost EPS, but they also provide a perceived margin of safety, letting investors know that a willing buyer of shares stands at the ready in the event of a market drop.

AIG and Citigroup are solid bookends in a portfolio. One is buying back stock while the other is likely to start doing so in coming quarters, which creates great value when shares trade below book value.

P.S. Buybacks are a cornerstone of a new investment strategy that has us so excited that we've decided to devote an entire newsletter to it. It's called Total Yield, and right now we're giving readers an exclusive glimpse at some of the top stocks we've already uncovered using this method -- including one that's gained an astonishing 247% over the last year. To get the name of this stock -- as well as 11 others that are currently posting "total yields" as high as 27.7% -- and view our free research, just follow this link.

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.