What Investors Can Learn From Facebook's Buyback Program

Facebook (NASDAQ: FB) recently announced plans to implement a $6 billion share buyback program in 2017, which left a lot of investors and analysts scratching their heads.

In this week's Industry Focus: Tech, Motley Fool analyst Dylan Lewis and Fool.com senior tech specialist, Daniel Sparks, explain why Facebook is looking to buy back billions of dollars worth of its own shares, whether or not this will be a good move for the company, and how investors should feel about the initiative. Also, the hosts compare Facebook's plans with two other recent tech buyback programs -- Alphabet's (NASDAQ: GOOG) (NASDAQ: GOOGL) fantastic buyback execution, and GoPro's (NASDAQ: GPRO) ill-timed program.

A full transcript follows the video.

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This podcast was recorded on Dec. 2, 2016.

Dylan Lewis:Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday,December 2nd, and we're talking aboutFacebook's$6 billion plan and tech share buybacks. I'm your host, Dylan Lewis, and I'm joined onSkypeby fool.com senior tech specialist, Daniel Sparks. Daniel, how's it going?

Daniel Sparks:Good, Dylan. Thanks for having me on the show.

Lewis:Yeah. Daniel, a surprise announcement about two weeks ago. Unfortunately, we missed hitting this because of the Thanksgiving holiday. Facebook said it plans to buy back $6 billion worth of its own stock.I think that surprised people a little bit.

Sparks:Yeah,it definitely came as a surprise to me.

Lewis:Yeah, you typically think of some high-growth tech company as one that will not be spending cash on its own shares. What are some of the terms that they announced?

Sparks:It's a $6 billion program, goes into effect in the first quarter of next year. There's no expiration date on it, or no stipulations as far as the timing goes. Management seemed to suggest that the stock price would matter. They did mention that as one of the factors that would determine how much they're buying back. But at $6 billion, that could be somewhat just to offset stock-based compensation. We'll talk about that in a little bit. But, this is a $320 billion market cap company. $6 billion isn't too big. But it is notable. They have $26 billion on their balance sheet right now, of which $4 billion is overseas. So, they do have the cash to spare, they have free cash flow coming in. That's it in a nutshell.

Lewis:Yeah. Very often, with these announcements, you'll see management say, "We will buy back shares opportunistically." That is that element of timing you're talking about. Seeing times they think sharesmight be undervalued. As a refresher on buybacks for investors who might be a little newer to the game, basically this is when a company buys back its own shares from the marketplace. There are a couple main reasons why they might choose to do this. One of them mainly being they believe the company is currently undervalued, so they believe buying them at a discount is accretiveto shareholders, as it reduces the number of shares outstanding, but also boost EPS (earnings per share), which people always love.

One of the other main reasons you'll see -- and I think this is something we'll see as a common thread with a lot of tech companies we'll talk about today -- is, it's a measure to offset the growing shares outstanding number. When you look at an industry where stock-based compensation is extremely common and tends to balloon, you see a lot of tech names using buybacks as a mechanism to reign in a rising share outstanding number.

I'll say, also, it's something that's kind of fairly common for more mature companies, companies that tend to have a decent amount of cash sitting around. I think part of the reason people were a little surprised to see this from Facebook is, like I mentioned before, you don't see a lot of high-growth relatively young public companies set up buyback programs. A lot of times, these businesses are so preoccupied with the cash that they're generating and taking it and reinvesting it back into the business in new initiatives, things that will fuel top and bottom line growth, that more Wall Street friendly moves like share buybacks orcapital return programs, more broadly, aren't even top of mind for them. What are your thoughts on this, Daniel?

Sparks:Like I said, at $6 billion, I do think this is not necessarily a capital return program, like you might think ofApple's,which goes to reduce the total share count. When we look at stock-based compensation in the 12 trailing months, it's over $3 billion. 2015 was just under $3 billion. Then, 2014, Facebook paid stock-based compensation of just under $2 billion. When you look at this trajectory of Facebook's stock-based compensation, it looks like when the company authorized $6 billion, that their stock-based compensation could potentially even equal $6 billion in 2017, when the program starts, especially considering how fast the company is growing, and that next year is supposed to be a big investment year. My general thoughts on this are, it does make sense, because Facebook is generating more cash flow, and like I said, it was a surprise when they first announced it, but after you begin to think about it, you see, Facebook does have a lot of cash, they're paying out a lot in stock-based compensation, but yeah, it's not necessarily capital return. It's more offsetting the dilution that comes with the massive stock-based compensation of retaining talent in Silicon Valley.

Lewis:Yeah, if you look at their shares outstanding since going public, they've gone from around $2.1 billion in 2013 to close to $2.9 billion now. Thatgives you an idea of stock-based compensations impact on the business, and their hopes that they can reign that in a little bit.

I will say, for Facebook investors, this might be a pretty solid time for them to be able to opportunistically buy shares. I know the authorization doesn't really allow them to start acting on this for a while. But you look at how they've been over the last month or so, for a company that's been a market darling for a long time, it seems like Facebook has fallen on some hard times.

Sparks:Yeah. I think that brings up why I can understand that they're actually doing this. Not only do they have the cash flow, but the timing does look good. Sure, Facebook has a P/E (price to earnings) ratio of 44X, but when you look at their forward P/E ratio, and their earnings are estimated to grow next year, that P/E ratio could get into the 20s, which, for a company growing as fast as Facebook, that's actually a pretty low P/E ratio. Then, you factor in what you might think of Facebook's competitive advantage, which, in my personal opinion, I think network effects are one of the most powerful ones, especially given Facebook's huge network effect. They have over 1 billion daily active users. I just think this is a good time for Facebook to be buying back their own stock.

Lewis:Yeah, you talked about them being at 44X as a trailing P/E right now. You go back a year, they were double that. That's not to say the company hasn't performed and the stock hasn't performed well. They are certainly up year to date over the last 12 months. I think it's just a testament to the fact that valuations creep down a little bit as the business has continued to perform, and those bottom line numbers look pretty good for them. So, could be a good opportunity for them. And certainly, at the scale they're doing it, it won't be something that's massively disruptive, because they're in such a great financial position.

One of the things I think is kind of curious,and maybe why some people were caught a little off-guard by this, was most of the rhetoric from Facebook's management in the most recent calls had been talking about how 2017 was a year of investment. We don't really think of that as share repurchase program. We think of that more as investing in the business, right?

Sparks:Right, and that's interesting. But I think that the narrative in these Palo Alto, Silicon Valley companies in the Bay Area, is really, they'restarting to think of investments as talent. Of course, they're making big investments in other areas, and I'm sure we'll see someacquisitions and some investments in the product. But at the end of the day, it's really expensive to retain talent, and Facebook realizes that for them to stay ahead, they're going to have to make some massive investments in talent. When you actually look closely at Facebook's most recent earnings call, you will see a huge emphasis on Facebook focusing on maintaining talent. So, when they say it's going to be a big investment year, I think a lot of that has to do with their expected jump in stock-based compensation. When you factor in this repurchase program with their stock-based compensation, all of this starts to make a little bit more sense.

Lewis:Yeah. To look to another company that seems to be using share buybacks kind of the same way, why don't we talk aboutAlphabeta little bit? This is a business that finally initiated a buyback program in late 2015, which was over 10 years after going public as Google. I think, really, when you look at what they've done with buybacks in the last year, that's going to be a blueprint from what we can expect from Facebook. It seems like it's been opportunistic, and it's really just to offset stock-based compensation again, right?

Sparks:Right. Alphabet is definitely a really good example of how investors might want to think about the Facebook program right now. Alphabet, in 2015, announced that they were going to to do a $5.1 billion repurchase program. At the time, you could look at the pace of their stock-based compensation and say, "This will probably equal out to about their stock-based compensation." And sure enough, over the next 3 months, it did equal out to about that, but they ended up exhausting all their funds before 12 months. They didn't have a stipulation on when the program would end, but my guess is, they had planned on it lasting over 12 months. Alphabet was opportunistic with this and started purchasing more of their shares, which, in retrospect, ended up looking good because the stock is up trading higher now. So, yeah, this is what Alphabet did, and,hopefully, it could be how Facebook's will look. Right now, we see the same thing with Facebook --the shares do look like they're pretty good value. Hopefully, Facebook will be opportunistic and maybe frontload this program. Again, there's no expiration date, so we're not exactly sure what this means. But yeah, if it looks anything like Alphabet's, that would be good.

Lewis:Looking forward out beyond just 2017, we see what Alphabet has done with a second program, this time a $7 billion program, on top of the $5.1 billion they already exhausted. I think that's a signal that this is going to be a mainstay now that they have established they want to be a little more Wall Street friendly under CFO, Ruth Porat. I wouldn't be shocked at all to see, once Facebook runs through this initial share buyback authorization, that they continue to have this be an ongoing program with subsequent authorizations,in order to continue to offset those rising share-based compensation numbers.

Sparks:Right. The $7 billion program does make sense.I think investors should be happy about this. You look, too, at Alphabet's free cash flow, their cash on hand. Their trailing-12-month free cash flow was $23 billion, so they definitely have this kind of money to be spending $7 billion on repurchasing shares. So that makes sense. And then the trajectory of free cash flow is huge. In 2015, free cash flow was $16 billion. It's definitely growing fast. A lot of excess cashhere to be repurchasing shares. I would say thatI would like them to be a little bit more opportunistic, with the kind of cash flow they have, and hopefully spend the money a little faster this time around. But, like you said, this is a continuation, the $7 billion. The one before was $5.1 billion, so maybe we're starting to see the beginning of what could turn into a more aggressive buyback. But, maybe it's too late then for it to be opportunistic. We'll see.

Lewis:Yeah, you have to realize there's also money that needs to be sent into the various segments they're looking to grow. So, those two companies that we talked about, both businesses that are in -- what I would say -- very stable and strong growthfinancial positions. They have a ton of cash on the books, and these buybacks made up a verysmall portion of what was available as cash, so very little business risk there.

On the flip side, and to talk about another tech buyback program that really didn't go very well, we can look atGoPro. This is a business that announced a repurchase program, and when they did, shares were downover 60% from where they were a year prior. So, it seemed like the timing could be opportunistic. The problem was, it didn't really seem to be, right?

Sparks:Right. At the time, GoPro was facing headwinds already. Clearly, you could see that from the stock price. And it could be said, "The stock price is down, now the company should be buying." At the time, even onlookersmight have looked at that and agreed with management. But the reality is, headwinds continued to come, the company continued to struggle, revenue ended up plummeting in 2016, the stock continued to fall. And this repurchase program ended up being a very bad decision. To its credit, GoPro did end up stop repurchasing shares. The repurchase program was $300 million, they only executed about $35 million of that, and they only did that in Q4 of 2015, then they didn't buy a single share back in 2016. That did help. But yeah, you look at the stock, and they paid around $23 on average per share when they spent that $35 million. Shares today are trading below $10. This was definitely a very poorly timed repurchase program. And not just poorly timed for the stock price, but now you look at GoPro's cash position, they had $280 million when they started this program. Because of headwinds they've faced, they only have $132 million in cash and equivalents today. $35 million is a big deal. At the time, it didn't seem like it. But now, spending $35 million on a $23 stock price that's now trading at $9 seems like a big mistake.

Lewis:Yeah, it doesn't seem like a great use of capital, and a good way to allocate capital. Like you said, thankfully, they decided to suspend the program, or at least pause it. That's that difference we talk about betweenauthorization and execution. Just because of business has a $300 million share buyback authorization does not necessarily mean that they will use all of it. It is simply what the board has decided they are able to do. Right?

Sparks:Right. And GoPro, similar to Facebook and Alphabet, the program ultimately would have mostly just balanced out stock-based compensation anyway, depending on how long they take to execute the program. But, in 2015, GoPro's stock-based compensation was about $80 million. You have a $300 million program, there's not much else to actually reduce the share count.

Lewis:Yeah, it didn't seem to me like their stock-based compensation was a runaway train the same way that it was for Facebook or Google. I think, if you're looking for some lessons on the GoPro side as an investor, two other things to keep in mind are, they allowed for this authorization and finalized it well within about a year and a half, maybe two years, of going public. That's a very tight turnaround to decide, you're issuing shares, then decide, you're buying back shares. That's a little bit of a head scratcher to me. If you look at what they'd authorized for the buyback, $300 million, and you do a breakdown of the actual proceeds that went to GoPro from their June 2014 IPO, before expenses, it was about $200 million. You have to wonder, "Why did you guys go public to begin with, if you didn't need this money?" It seems bizarre as a shareholder.

Sparks: It does. That brings up, if you were to think about, what if they actually -- instead of doing this $300 million program -- doubled down on execution and bringing their products to market? Would things have turned out differently? It's something to think about.

Lewis: And that's ultimately the consideration with any of these share buyback programs, that thisall fits into a company's capital allocation program. And there are a bunch of different ways that a company can choose to use the cash and money it's been lent that's available to them. Buybacks is one, but investing in the business, fueling growth in segments that might be really promising is another. When your business isn't doing all that well, buying shares back might not necessarily be the best thing to do long-term. It might make things cosmetically look good short-term, but it's not really a super sustainable thing to be doing.

Sparks: Right.

Lewis: Anything else on GoPro, Alphabet, or Facebook, before I let you go, Daniel?

Sparks: No, I think this was good.

Lewis: Awesome. Thanks for joining us, man!

Sparks: Thanks.

Lewis: Well,listeners, that does it for this episode of Industry Focus.If you have any questions, or just want to reach out and say hey, shoot us an email at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. You've probably heard Chris Hill mention our daily news flash briefing that we produced for Amazon Echo. Now you can get that brand-new skill from The Motley Fool. You can get stock quotes, create a watch list, ask Alexa how your portfolio is doing, and it's all free. For more details, including a demo on how it works, just go towww.fool.com/alexa. Of course, if you'relooking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows at fool.com/podcast.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Daniel Sparks, I'm Dylan Lewis, thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Daniel Sparks owns shares of Apple and Facebook. Dylan Lewis owns shares of Alphabet (A shares) and Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, Facebook, and GoPro. The Motley Fool has the following options: long January 2018 $90 calls on Apple, short January 2018 $95 calls on Apple, short January 2019 $12 calls on GoPro, and long January 2019 $12 puts on GoPro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.