2 Stocks to Cash in on the Buyback Frenzy

When Cisco Systems (Nasdaq: CSCO) announced last week that business trends had slowed, its shares quickly moved toward a 52-week low. Management could at least take solace in the company’s bulletproof balance sheet, sporting $39 billion in cash. So, management’s announcement on Thursday that the company would buy back yet another $10 billion in stock should have come as no surprise. ($67.5 billion in stock has already been re-absorbed through previous buybacks, prior to accounting for any new option-related shares.)

And Cisco is not alone. A whole slew of companies have been announcing buyback plans, which is likely due to the fact that companies have been generating so much cash in recent quarters. Of course, not all buybacks can be viewed in a promising light. Defense contractor Lockheed Martin (NYSE: LMT) plans to buy back up to $3 billion in stock simply because growth opportunities in the defense sector are fast disappearing and Lockheed has no compelling areas to invest in right now.

And other companies issue buyback announcements simply as a P.R. move. Potash (NYSE: POT) announced plans to buy back billions in stock after a takeover bid by BHP Billiton (NYSE: BHP) failed to come to fruition. But Potash’s shares have nearly tripled in the last two years, and for a cyclical play, are quite pricey at more than 20 times projected 2010 profits. Management would be foolish to follow through with the buyback plan right now.

Cypress Semiconductor (NYSE: CY) is a clear example of a “just in case” buyback. The company is firing on all cylinders as sales and profits rise at a fast pace, and shares are at a multi-year high. Cypress has announced a hefty $600 million stock buyback, but would likely only follow through with it if shares fell back toward the $10 mark in a weakening broader stock market.

To find compelling stocks based on the buyback angle, I looked at all companies that have announced buybacks in the past 30 days that represent at least 10% of shares outstanding.

In the table below, you’ll find price-to-earnings (P/E) ratios based on projected profits. Yet most analysts don’t factor buybacks into their earnings models. So if the buybacks are completed, the share counts should shrink, the EPS forecasts should rise, and the projected P/E multiples would move even lower.

Here are the best-looking ideas in the group:

Rent-A-Center (Nasdaq: RCII)
As a rule of thumb, it’s best to do a buyback when shares are near multi-year lows. This furniture rental company may be the exception. Rent-A-Center has announced a series of growth initiatives, that if successful, would make the company’s impressively low P/E multiple stand out.

First, the company is rolling out mini-stores inside other retailers’ stores (a win-win, since some retailers are now operating stores that are too large for the slow levels of traffic). There are currently 200 of these store-in-a-store branches, and management hopes to ramp that to 800 by 2013. In addition, Rent-A-Center is aiming to expand into Mexico and Canada, which could expand its total retail footprint by +25% in the next four years. The Mexican opportunity is quite large, with a potential for 400 stores, according to management.

But the real opportunity comes from an eventually improving employment picture, which tends to lead to a spike in new household formation (of both renters and owners). This business model really took off in the 1990s, when twentysomethings were starting families but couldn’t yet afford to buy a house full of furniture.

Without these initiatives, Rent-A-Center would likely be a very low-growth business model — at least until the economy turns up (which explains why shares trade for less than 10 times profits). Noting that low multiple, management has already bought back more than $500 million in stock, (shares outstanding has already shrunk by -30% in the past decade) with plans to buy back another $300 million under the current authorization. That could reduce shares outstanding by another -15%.
#-ad_banner-#Aeropostale (NYSE: ARO)
This teen-focused retailer has already bought back more than $1 billion in stock in the past five years (taking shares outstanding lower in each of the last six years), and just announced plans to remove another $300 million from the share count. The time is right. Shares are off their highs, sport very low P/E multiples, and analysts think the company could see a very strong holiday season.

Brean Murray thinks you shouldn’t just buy this stock based on the buyback: They see Aeropostale “as the key winner in the teen segment,” and they predict the retailer will show a high degree of earnings power when the economy rebounds. Indeed, if the share count keeps dropping, then Aeropostale’s earnings forecasts will prove to be even more conservative.

Action to Take –>The real test is whether a company buys back more shares than it issues in stock options. Companies like Aeropostale and Rent-A-Center have a proven track record of shrinking the share count. Their low multiples and further share count shrinkage sets the stage for a higher stock price down the road and are good portfolio candidates.