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How You Can Profit From The $1 Billion Buyback Playbook

David Sterman

Here at StreetAuthority, we spend a great deal of time focusing on dividend-paying stocks.

Rising dividend payments have become the hallmark of the modern investing era as companies begin to return unneeded cash back to its rightful owners -- the shareholders.

Many companies are so flush with cash and robust cash flow that they continue to devote huge sums of money to stock buybacks as well.

For investors, these buybacks can help restore luster to a flagging stock price. A few weeks ago, I said that Apple (AAPL) could boost its lackluster stock with a massive buyback.

I suggested the company use its own cash and also borrow funds to amplify the buyback's effectiveness.

Well, that's precisely what Apple did, and shares have risen more than 10% in just those past few weeks.

I looked at this past month's other major buyback announcements to see whether any other stocks might benefit as Apple has. I found 12 companies that have recently announced a share buyback of at least $1 billion, or a buyback large enough to reduce the share count by at least 7%. Here's what I found.

Right away, you'll notice two standouts in terms of buyback spending as a percentage of market capitalization. Both Denny's (DENN) and Rent-A-Center (RCII) are in a position to significantly shrink their share counts. As is the case with Apple, these companies are willing to take on some debt to buy back stock, which may seem like a risky move. But both of these companies are generating stable financial results, and as long as the economy doesn't stumble badly, these moves could really pay off.

Nearly two years ago, I spotted the early signs of a turnaround at Denny's and noted management's plan to buy back shares. Since then, the share count has fallen by around 5% to 97 million.

Still, for a company that has generated $40 to $50 million in free cash flow in each of the past two years (along with just-released guidance of a similar amount of free cash flow for the current year), earmarking another $120 million toward stock buybacks is a pretty bold stroke. That would cut the current share count by a quarter, setting the stage for very robust per-share profit gains, even if sales growth is muted.

How can Denny's afford to do that? Well, as the company's free cash flow has strengthened, Denny's has been able to secure much lower borrowing terms from its lenders, and the company's board has decided to convert those interest expense savings into buybacks.

I took a look at this furniture and appliance rental chain in late 2010, noting that a then-announced buyback plan could shrink the share count by up to 15%. Indeed, the share count has now moved below 60 million. It stood at 70 million in 2006 and 80 million in 2004. Rent-A-Center's new $1.25 billion buyback plan could radically accelerate that trajectory.

Frankly, the move makes ample sense, as sales are growing just 5% annually, albeit with EBITDA (earnings before interest, taxation, depreciation and amortization) margins of an impressively robust 30%. Rather than invest its profits in further growth initiatives that may or may not pay off, management instead prefers to radically shrink the share count.

Right now, consensus forecasts anticipate 2014 earnings per share (EPS) of around $3.40. Yet a robust share buyback could hike that figure to $4 or even $5 in a few years, and if that happens, the current $35 share price looks like a great entry point.

Like Apple and Denny's, Rent-A-Center is taking advantage of very low interest rates: Its newly issued $250 million debt will carry an interest rate of just 4.75%. Considering that this company's operating cash flow yield is around 15%, this debt-fueled buyback makes ample sense.

Risks to Consider: In the event that the economy weakens badly and current cash flow levels evaporate, then all three of these companies' buyback plans would look foolish.

Action to Take --> The era of low interest rates and high cash flow has changed the equation for many companies. It now makes sense for some companies to measure their returns on assets, equity and investments and if borrowing costs are well lower than these returns, then taking up debt to buy back stock could be one of the wisest moves to boost per-share profits and the share price.

It's also wise when companies buy back stock that is trading below tangible book value. As an example, I suggested last year that shares of banking giant Citigroup (NYSE: C) might double if the company bought back stock at such a deep discount to book. Shares have almost reached my target price.

Unfortunately for Citigroup, regulators forced the bank to wait on buybacks until capital levels are stronger. In the table above, you'll note that Citigroup has finally announced a billion-dollar buyback program. It would have been nice to proceed with the plan when shares were trading for half of book value, but as they are still less than 100% of book value, the buyback still makes sense.

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