Investor dilemma: Should companies reinvest or buyback stock?
There are basically two main uses for surplus corporate cash. One is reinvestment in the business, like building new factories, hiring more workers, and spending on research and development. The other is to return money to shareholders, either through dividend payments or stock buyback programs.
These days, it's become more difficult for some investors to figure out which they prefer.
For example, take Facebook. The social media giant saw its stock drop the day after reporting earnings and revenue that topped analysts' expectations. The weakness in shares was attributed to the company's plans for spending in 2015.
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Facebook Chief Financial Officer Dave Wehner said that the company is expecting costs to increase by anywhere from 50 percent to 70 percent as the company looks to invest in future growth. That includes, but is not limited to, investing more money in the instant messaging service WhatsApp, virtual reality company Oculus and photo sharing service, Instagram. All three business units were high profile acquisitions that Facebook spent billions of dollars to make. Now, it will try to deploy resources so that each of those businesses can generate revenue and eventually profits for the company in the future.
The negativity over things such as the planned increases in future spending are leading some analysts who cover Facebook stock to recommend buying on weakness. According to analysts polled by Factset, Facebook still has an average target price of $88.68 per share, which implies around an 18 percent gain from current levels, with 89 percent of analysts who cover it rating it as a "buy" or equivalent.
RBC analyst Mark Mahaney told CNBC's "Squawk on the Street" that he thinks it's likely that Facebook could very likely see 30 percent to 40 percent earnings growth over the next few years. If Facebook has placed its bets correctly, that increased spending on future growth could be a big part of that story.
Another technology giant that has seen its shares take a hit in recent trading is IBM. The company has received a lot of investor and media attention over the years for its multibillion-dollar share repurchase programs. At one point, it was the toast of Wall Street as it took large chunks of its profits and distributed them back to shareholders through those buybacks, in addition to dividend payments. These days, the company has been accused by some of using share repurchases to "engineer" growth in earnings per share.
The concept is fairly simple. Let's say a company makes $100 in profits a year. It has 100 shares of stock outstanding. That means that earnings per share, or EPS is $1 per share. Now imagine that the company engages in a stock buyback program and buys back 50 of those shares. Profits can stay static at $100 the following year, but since there are now only 50 shares outstanding, EPS has doubled to $2.
Companies that are more mature in their life cycle, such as IBM, often will choose to return a good portion of cash they generate to shareholders. According to an IBM spokesperson, over the course of the last decade, the company has returned $118 billion in such a fashion, with $26 billion of that in dividend payments and $92 billion through share repurchases.
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However, the company has been accused by some of sacrificing future growth by not reinvesting back in the company. IBM points out that during that same decade span, it has invested more than $133 billion back into the company, either through capital expenditures, acquisitions or research and development.
So far this year, IBM has announced a $1 billion investment in its Watson cognitive computing program; another $1.2 billion for building up to 40 cloud computing centers around the world, and $3 billion in semiconductor R&D. Analysts have an average target price of $170.78, which implies just 4 percent upside from current levels. Just 14 percent of analysts polled by Factset have a buy or equivalent rating, while 75 percent rate it neutral, and 11 percent rate it sell.
So, this is a tale of two tech titans. On one end, there's Facebook. The poster child of next generation internet companies that are revolutionizing the way we consume and distribute information. At current levels, the company is worth $197 billion and trades at 72 times earnings according to data from Factset. On the other end, there's IBM. One of the most iconic companies in American history. One that's reinvented itself at different times to adapt to an ever changing environment. It's worth $162 billion and trades at 13 times earnings.
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There's negativity regarding both companies, but for differing reasons that happen to be flip sides of the same coin. Some investors don't like the idea that Facebook will be ramping up spending in the coming year on projects that could add to future growth. At the same time, some investors don't like the idea that IBM is ramping up spending on share buybacks, arguing that the company should be investing more in future growth.
There are very few apples-to-apples comparisons to be made between the two companies. The investment thesis and business models of each are both very different as well. However, the similar reaction in share price due to Facebook's plan to boost expenses in order to grow businesses, and the perception that IBM isn't spending enough on future growth means that there's a dilemma brewing about the best use of cash.
Stocks of both companies are being weighed down because one is being perceived as spending too much on future growth, and one is being perceived as perhaps not spending enough. One question facing potential investors in both is what the optimal mix of reinvesting for growth versus returning capital to shareholders is? Another question is whether the weakness in either stock, or both represents a buying opportunity? The jury is still out.