Buybacks Make a Comeback
from
May/June 2002
by Judy Ward
“You can’t put lipstick on a
pig’s face and make it look pretty,” Nikhil Varaiya says. He’s talking
about stock buybacks. That’s a harsh reality for companies that hope to
jolt their slumping stock upward by repurchasing their shares. “If you
have fundamental problems with growth and profitability, a buyback
can’t change that,” says Varaiya, chairman of the department of finance
at San Diego State University and a student of share repurchases. “In
the very short run, there is a little blip in the stock price. But the
board of directors should recognize that what drives share price is
real profitability and real growth in earnings.”
However, when a profitable company has sound reasons for repurchasing its shares, such as excess cash flow, a well-designed buyback plan can help the stock outperform the market handsomely—in time. “The market is very slow to respond to these things,” says David Ikenberry, a professor of finance at Rice University, where his studies of the long-term effects of buybacks have made him a little more sanguine than Varaiya. His research shows that after four years the shares of companies that purchase their stock do beat the market, sometimes handsomely. But he warns, “Recognize that whatever benefit you are looking for, it is not going to materialize quickly.”
The warning is especially timely because many U.S. companies have stock buybacks in the works, and most are probably hoping to lift their share prices. “Right after the September 11 tragedy we had a huge surge,” says Ikenberry. About 300 companies, including Cisco Systems and Starbucks, announced buybacks in the two weeks that followed, partly because the Securities and Exchange Commission temporarily relaxed some repurchase rules governing volume and the like.
A well-planned buyback has several advantages. It can offset the issuance of stock to employees, deploy excess cash flow, return money to shareholders more efficiently than twice-taxed dividends, and improve capital structure.
And yes, it can strengthen the stock. The case of Hewlett-Packard, however, illustrates how little a repurchase may impress investors. HP “has spent an enormous amount on buybacks,” says Varaiya. In September, the company resumed a $1.8 billion repurchase of shares. But that has raised the stock price only slightly, from $15.99 to $19.05 on March 15. Some investor caution can be laid at the door of HP’s problems with the Compaq merger. Papa John’s International doesn’t have this excuse. The pizza chain announced a $275 million buyback in December 2001, when its stock was $26.40. On March 15, the price was just $27.52.
When does it make sense to purchase your own stock? Pressed to buy back shares of Berkshire Hathaway after the company’s poor showing in 1999, chairman and CEO Warren Buffett explained his philosophy in a letter to shareholders. “There is only one combination of facts that makes it advisable for a company to repurchase its shares,” he argued. “First, the company has available funds—cash plus sensible borrowing capacity—beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated.”
Among those that seem to meet these criteria is Biomet Inc., a Warsaw, Indiana, maker of medical supplies. Even so, it opted for a buyback only after serious soul-searching, according to CEO Dane Miller. “We wanted to make sure that we weren’t artificially increasing the share price,” he explains. But Biomet had about $500 million in cash on hand, Miller says, and had invested it cautiously—“a lot of T-bill kind of things.” With interest rates dropping, the company saw its return on that money decline. “We began to step back and look at where else we could conservatively invest the money,” Miller recalls. “And Biomet is a very conservative investment. We feel we are in a market driven by demographics.” He says that as baby boomers age, they’ll need more products like the orthopedic-surgery equipment the company makes.
Miller first mentioned a possible buyback at the fall 2001 board meeting, adding that the move would also counter a share dilution brought about by the company’s employee stock-option program. The board was receptive, he says, but not convinced. So Miller, along with Biomet’s chairman and its CFO, studied the idea more fully before the winter meeting. By the time that rolled around, the company’s excess cash had continued to grow while the return on its investments dropped to 2.5%. That sold the board on using the money for a buyback, and the directors authorized the purchase of up to $124 million of Biomet’s outstanding common shares.
Miller advises others not to try using a buyback just to goose the stock price. “That shouldn’t be the goal of any company. Sooner or later it will find its own level,” he says. He adds that if a repurchase announcement had caused Biomet’s stock to jump, only to fall again, “we would have looked like fools.” Instead, the stock went up and stayed there. It recently traded at more than $32, close to its 52-week high.
LandAmerica Financial Group Inc., a title-insurance and real-estate-services company based in Richmond, Virginia, has also announced a buyback—but with a different rationale. To hear chairman and CEO Charles H. Foster Jr. tell it, buybacks make for pretty simple business. “It’s not something that’s particularly complicated,” he says. “You’ve got shareholders, you want to return value to them, and you have three ways to do it: dividends, a stock buyback, or an acquisition.”
Adds Foster: “We are in a very cyclical business, so our cash flow is volatile. With interest rates being what they are right now, we don’t know exactly what our business scenario needs to be. For us to establish a dividend is not practical, simply because you can’t lower dividends—there is a perception that a company is in dire straits if it lowers the dividend.”
That left a buyback or an acquisition. In December LandAmerica said it had allocated $25 million to the purchase of as many as 1.25 million shares, or about 7%, of its outstanding common stock over the next year. The company still has options: If an alluring deal pops up, it can use the money for an acquisition instead. “We wanted the flexibility to choose between share repurchase and an acquisition,” Foster says.
So what might happen to the share prices of Biomet and, if it goes through with the repurchase, LandAmerica? Ikenberry’s research tracked the stock performance of U.S. companies that made buyback announcements in the 1980s. Over the four years following those announcements, the study found, companies that repurchased their shares typically outperformed the market by 12.5%. To zero in on potential cases of mispricing, Ikenberry and his colleagues also isolated value stocks, which would logically have the greatest chance of being undervalued. Sure enough, after a buyback those stocks beat the market by 45% over the four-year period. The numbers are supported by another study Ikenberry co-authored, on the results of buybacks announced by Canadian companies between 1989 and 1997. These companies beat the market by 7% annually on average, while value stocks ran ahead by 9.1%.
But in the short term, Ikenberry says, studies show only a 2% bounce in share prices. Does a buyback prop up the price of a company’s stock if that is the only goal? “The answer is obviously no,” says Ikenberry. “You don’t repair a mispriced stock in a short period of time.”
Yet that’s just what many companies try to do, according to Doug Wright, a Denver-based partner at the law firm Faegre & Benson who advises clients on repurchase plans. Companies are tempted to think that they can attract buyers by reducing the denominator in the earnings-per-share calculation—in other words, reducing the number of shares outstanding—and thus raising earnings per share. Or, says Wright, they imagine buyers will be hooked by the “perception that if a company is buying its stock, it believes the stock is undervalued.” Some outfits convince themselves that their shares are undervalued when in fact they aren’t. “If you look at this strictly as a way to increase your share price, you may be making a bad bet,” Wright says.
For a case study of a corporation that believes steadfastly in buybacks for the long term, look at Valassis Communications Inc. of Livonia, Michigan. A printer of newspaper inserts and other marketing materials, Valassis allocates at least 50% of its yearly free cash flow to stock repurchases. Over the past six years, it has reclaimed more than 14.5 million shares; about 54 million are outstanding.
Why so many bucks devoted to buybacks? Valassis’ capital spending totals only about $15 million yearly, which gives it $100-plus million in leftover cash. “It’s really one of the things that is unique to us: We throw off a lot of cash flow, and reinvest it in the company,” says Robert L. Recchia, a board member who is also the corporation’s executive vice president and CFO. “Part of our strategy is to grow earnings per share faster than our top line.”
In January Valassis took the plunge again, saying that its board had authorized a fourth consecutive five-million-share buyback—about 9% of the stock outstanding. “I think it is a cornerstone of our financial strategy,” Recchia says. “Fundamentally, we believe that one of the things that is attractive about our stock is that we do have the ability to buy back significant amounts of our stock on an ongoing basis.”
How well the plan is working is unclear. In the past six years,
Valassis’ earnings per share have more than tripled on revenue growth
of only one-third, and the share price has more than doubled—about in
step with the S&P 500.
