2 Companies Spending Billions to Buy Back Their Own Stock

With companies sporting abnormally high levels of cash these days, they’re feeling greater pressure to give something back to shareholders. A dividend hike is the normal route, but an increasing number of companies are initiating massive stock buybacks.
I looked at some intriguing buyback-fueled stock picks a month ago  and since then, a fresh crop of companies have announced major stock buyback programs. I’ve compiled a list of the companies with the largest buyback programs announced since Thanksgiving. In the table below are six companies that have announced plans to buy back at least $1 billion in stock, all of which have the potential to shrink the share count by at least 5%.

After taking a deep look at all six, here are the two stocks that appear to have the most upside.

Seagate (NYSE: STX)
This maker of hard disk-drives aims to show the power that a massive buyback can bring. If its plans are fully realized, its share count will be at least 25% lower in a few years. When coupled with improving industry dynamics, it could turn Seagate into an earnings powerhouse.

The $2 billion buyback plans came after the company decided to end talks about going private. Management says that offers for the stock (presumably in the mid-teens) were too low. They believe that concerns about the demise of hard disk drives are overblown, which was likely a factor in negotiations. Some tech watchers think that solid state memory drives will replace disk drives in coming years, but most tech watchers doubt we’ll see such a move. Seagate has proof: demand has started to rebound in recent weeks, leading management to raise guidance.

Analysts took a look at that raised guidance — and the massive share buyback — and started boosting their ratings and price targets. Needham sees shares rising from a recent $15 to $19, and now thinks fiscal (June) 2012 earnings per share (EPS) will hit $2.35 after a likely slump below $1.50 in the current fiscal year. Needham declines to factor the stock buyback into its profit forecasts, yet notes that it could add $0.50-$0.75 to EPS in fiscal 2012, and $1.00 to EPS in fiscal 2013. That sets the stage for EPS in excess of $3 by then.

How will Seagate pay for the buyback? The company will likely use up half of its current $2 billion gross cash balance and also announced plans to issue fresh debt. Avian Securities notes that Seagate should also generate $100 to $200 million in free cash flow every quarter. Brean Murray notes that “fiscal 2012 could be an outstanding EPS growth year even without the share repurchase,” adding that “if STX were to generate $2 in calendar 2011 EPS, this could push the stock towards $20.” That’s more than 30% upside from current levels, and shares have likely limited downside after the recent boost in guidance and that massive stock buyback.

Encana (NYSE: ECA)
Do you believe that natural gas prices will eventually move up from their current multi-year lows? That’s the thesis of some investors that foresee a steady switch to natural gas as a power source for our nation’s truck fleet. After all, some have coined the United States as “the Saudi Arabia of natural gas.” Rising demand could lead prices to rise from a current $4.25 per million BTUs to $6. Such a move would create a powerful tailwind for Canada-based Encana, which has brought in partners to double its production. The company has already raised $4 billion in the last three years, and if recent talks with China National Petroleum come to fruition, another $2 billion could come in the door.

Encana focuses on what’s known as “unconventional gas,” which means it pursues potentially massive energy fields that are difficult to tap unless you’re willing to commit a lot of money. And that’s what the company has done, spending an average of $7 billion on capital expenditures in each of the last five years.

Thanks to those heavy investments, Encana was able to generate nearly $2 billion in free cash flow (FCF) in 2009, even as natural gas prices remained weak. That FCF figure likely slumped in 2010 as the company throttled back development spending, but the recent cash injections from new partners means that spending — and eventually free cash flow — should start to rebound. And that’s emboldened management to start buying back stock, especially as it sits at levels last seen back in 2005.

Right now, Encana plans to buy back around 37 million shares, but that may just be the beginning. If production surges in 2011 and 2012, as the company suspects, and if natural gas prices can rise even modestly, then Encana should become a cash machine and future buybacks could be well larger.

To be sure, Encana has its detractors. “The street continues to dislike its strategy of growth into a weaker gas market,” note analysts at National Bank Financial. They recently upgraded shares to “Buy,” believing that sentiment toward Encana and other gas plays is “overly pessimistic.” They favor Encana since it “is one of North America’s low-cost producers” and expect shares to rise from a current $28 to $40, although if natural gas prices start to rebound in the next 12-18 months, then that price target should prove to be too conservative.
Action to Take –> Big buybacks are a company’s way of saying “our shares are too cheap.” In the case of Seagate and Encana, there has been an awful lot of pessimism around their business models. Their buybacks signal an outlook that could be higher in 2011 and 2012 than many currently expect. You’d do well to consider either of these names.