When To Do A Stock Buyback
from
May/June 2006
by Al Ehrbar
Maybe
Wall Street should think about replacing its famous 7,000-pound bronze
bull with a giant boomerang. Stock buybacks by the 1,000 largest
companies in the U.S. jumped 55%, to $257 billion, in 2004, and
probably exceeded $400 billion last year. And it appears likely that
public companies will shell out even more money for their own shares
this year. In the early weeks of 2006, boards were authorizing
repurchases at a rate of more than four a day, up from three per day at
the same time a year ago, according to TrimTabs Investment Research,
which tracks buybacks. Actual repurchases were beating the pace set in
the first quarter of last year by about $300 million a day.
The buyback boom obviously indicates optimism on the part of CEOs and
boards—at least about the shares of their own companies. If directors
didn’t believe their shares were a good buy, they would simply sit on
the cash, pay it out in dividends, or use it to draw down debt. But
what’s really driving the current wave of repurchases? Why are so many
companies spending so much to buy in their own shares? And how should
you think about the issue when the management team proposes—or fails to
propose—a share repurchase? (For the way this affects investors, see
“What Buybacks Do to Stock Prices” on page 66.)
The principal motivation behind the huge increase has been the rather
pedestrian one of returning excess cash to shareholders. That may not
be exciting, but it is a testament to the fiscal health of corporate
America. Many companies are awash in free cash flow, thanks to the
current economic expansion, with far more money coming in than they
need for reinvestment or new projects. So they have elected to
distribute some of it to shareholders, with three-quarters of the
increase in payouts taking the form of share repurchases rather than
dividends. While repurchases by the 1,000 largest companies increased
by $241 billion from 2003 to 2005, their dividend payments rose by just
$83 billion, to $264 billion.
Although it may not be immediately obvious, dividends and share
repurchases are equivalent ways of distributing cash to shareholders.
Here’s why: When companies pay dividends, they distribute cash
proportionately to all shareholders, and the stock price drops by the
amount of the dividend per share on the ex-dividend date. With
repurchases, the share price doesn’t decline, because the company gets
something—outstanding shares, or equity—in return for the cash. Divided
among the remaining shares, the value of the shares bought in is equal
to the dividend the remaining shares would otherwise have received.
Repurchases are sometimes pieces of much grander designs, of course,
especially if a buyback is part of a leveraged recapitalization or if a
company is trying to send a strong message that its financial strategy
has changed or its stock is woefully undervalued. But when the purpose
is simply to get cash into the hands of shareholders, a repurchase is
little different from a regular or special dividend. Many people argue,
however, that taxes make repurchases a better deal for shareholders,
even after the cut in dividend taxes to the same 15% as capital gains.
That’s because repurchases allow shareholders to choose whether they
want to pay any taxes at all right now, by selling some of their
shares, or whether they prefer to hang on. Says Joe Nowicki, treasurer
of Herman Miller, an office-furniture company: “We prefer repurchases
to special dividends because repurchasing doesn’t force a decision on
shareholders.” One who disagrees is Charles M. Elson, director of the
John L. Weinberg Center for Corporate Governance at the University of
Delaware. He believes the 2003 tax cut put dividends on an even footing
with repurchases.
The biggest share repurchaser of all is Microsoft, which announced in
July 2004 that it would buy in up to $30 billion of its shares over the
following four years. The company repurchased more than $17 billion of
stock in 2005 and said in October that it would complete all the
purchases by the end of this year, 18 months ahead of schedule. Intel,
a close second, said in November that its board had authorized up to
$25 billion of repurchases. More recent announcements have included
Time Warner’s stated intention to do up to $20 billion of repurchases
by the end of 2007 and buyback authorizations of $5 billion at Comcast,
$2 billion at Marathon Oil, and $1 billion at Symantec. Plenty of
others are spending similarly large amounts relative to their market
capitalizations. Ball Corp., a container and aerospace company,
repurchased $393.7 million of its stock last year, up from $85 million
in 2004. Electronics retailer Best Buy tripled its multiyear repurchase
authorization from $500 million to $1.5 billion in April 2005 and spent
$434 million on its shares in the three fiscal quarters that ended in
late November, up from $174 million in the same period a year before.
Becton Dickinson, a medical-supplies-and-technology company, spent $550
million on share repurchases in the fiscal year that ended last
September, up from $450 million and $350 million in the two previous
years.
Companies actually have the means to repurchase far more shares than
they have been buying, even at the recent heady pace. Indeed, an
increasingly frequent criticism has been that corporations have amassed
so much cash, held in the form of marketable short-term-debt
securities, that they’ve become underleveraged. Some 25% of the
companies in the Russell 3000 stock index now have holdings of
short-term securities that equal or exceed their total debt, including
the capitalized value of off-balance-sheet leases. In other words, they
have zero or negative net debt. That kind of balance sheet makes sense
for a biotech start-up but not for a mature, comparatively stable
company that has the significant tax advantage of being able to deduct
interest payments on debt (and pays punishing taxes on interest
income).
Microsoft is the most notorious of the cash hoarders, even with last
year’s $17.3 billion share repurchase. Its portfolio of cash
equivalents rose slightly, to $30.6 billion, leaving its net debt at
minus $25.4 billion. But Microsoft is far from being the champion of
negative leverage. Of the Russell 3000 companies, 270 have negative net
debt that is even larger as a percentage of their total market value.
Some observers see all that cash as a huge positive, since it reduces
the underlying riskiness of stocks and is a strong indication that
companies are resisting the temptation to overpay for acquisitions.
Others, including Charles Elson of the University of Delaware, take
issue with the cash buildup. “Cash should be invested or returned to
investors,” says Elson. “Companies shouldn’t maintain large cash
balances that they don’t need.”
When your company distributes cash, you have plenty of reasons to
prefer repurchases to dividends. One minor advantage is that
open-market share repurchases are more efficient: It’s cheaper to buy
stock for a few pennies a share in commissions than it is to cut
dividend checks and mail them to legions of shareholders. The major
advantage, however, is the flexibility that repurchases provide for
paying out volatile cash flows. Companies can pump up their buying when
business is good and ease off on repurchases when cash flows ebb, as in
2002 and 2003, or when they need cash for capital investments. As John
Considine, executive vice president and CFO of Becton Dickinson, puts
it, “We can turn off the buybacks if we need the cash for acquisitions
or other purposes.”
Dividends, on the other hand, are famously sticky. Boards are extremely
reluctant to cut them, and with good reason—any reduction sends an
awful message to the stock market. When General Motors cut its dividend
in half in early February, for instance, its stock slid nearly 6% over
two days. The market reacts so negatively precisely because generations
of managers and boards have cut dividends only when they had no other
choice. One consequence of this history is that companies are reluctant
to raise dividends in good times beyond the level they are confident
they’ll be able to maintain in the next downturn. As proponents of
buybacks see the world, companies get too little credit for raising
dividends and too much blame for cutting them.
R. David Hoover, chairman and CEO of Ball Corp., has a keen
appreciation of the value of flexibility. Ball has raised its dividend
two times in the last three years but has kept it at a comfortably
sustainable level of about 1% of the current market price. The vast
bulk of its shareholder distributions now take the form of buybacks.
Last year it spent about $10 on share repurchases for each dollar of
dividends. “Dividends have an air of permanence,” Hoover says. “I was
CFO in the early 1990s when we had to radically cut the dividend. Those
were tough days.”
GM would have made fewer headlines if it had eliminated repurchases
instead of halving its dividend. Trouble is, the company had to
terminate its once-aggressive share-repurchase plan some years ago to
conserve cash. The real wonder is who GM thinks it’s fooling by
continuing to pay out $1 a share in dividends when it is so strapped
for cash.
Ball Corp. provides an interesting case study in the flexibility of
repurchases. Dave Hoover began last year intending to buy back about
$150 million of the company’s shares. But that was before he and the
board decided to repatriate $488 million of capital from overseas. The
repatriation set the stage for restructuring the company’s liabilities,
replacing older, high-priced debt with new debt and a larger revolving
credit agreement. In the end, Hoover was able to boost Ball’s
repurchases to $328 million and still end the year without increasing
the company’s debt. This year Ball again intended to do $150 million of
repurchases, but reduced the target substantially after embarking on
two acquisitions. “We want to keep everything tight,” says Hoover.
“They have a similar thought pattern at Energizer, where I’m a
director. It’s just part of managing the capital structure.”
Flexibility has a lot more to offer than the mere comfort it affords
managers and directors. Repurchases can also have a positive influence
on management behavior. A 2004 survey of how finance executives view
payout policies confirmed that those sticky dividends can distort both
financial and operating strategies. The survey, titled “Payout Policy
in the 21st Century,” was conducted by Alon Brav of Duke University,
John R. Graham, also of Duke, Campbell R. Harvey of Duke and the
National Bureau of Economic Research, and Roni Michaely of Israel’s
Inter-Disciplinary Center and Cornell University. They found that many
finance executives will go to almost any lengths to maintain dividends.
“Some executives,” they write, “tell stories of selling assets, laying
off a large number of employees, borrowing heavily, or bypassing
positive NPV [net present value] projects before slaying the sacred cow
by cutting dividends.” But those same executives say they will not pass
up good investments or disrupt the business to make repurchases.
The logical flip side of this behavior is that dividend payers can be
tempted into unprofitable investments or wealth-destroying acquisitions
when cash is plentiful. A dividends-only payout policy risks causing a
company to make all kinds of mistakes, in bad times and good. And on
balance, the fear of raising the dividend too high will probably cow a
dividends-only company into paying out less cash to shareholders over
the long run.
Special dividends—like Microsoft’s $33 billion, $3-per-share payout in
2004—are also a flexible way to distribute cash to investors, but many
companies still prefer repurchases. One reason is that repurchases can
be spread throughout the year, while special dividends are lumpier.
Companies with a particularly sophisticated understanding of the role
of buybacks all treat them as a sort of residual decision—something
that is always subsidiary to operating and financial strategy. Herman
Miller is one of those. “We do an annual capital-structure review with
the board,” says treasurer Joe Nowicki. “We first assess cash and
capital-spending needs in the context of our goal to double our
business by 2010. Any excess cash goes first to the business strategy.
Two other factors are our pension-funding needs and maintaining the
regular dividend. That is currently at about a 1% yield, which is where
we want it to be.”
After this—and an assessment of whether the business strategy calls for
adding or reducing debt––“the preferred way to return excess cash to
shareholders is through repurchases,” Nowicki says. Herman Miller has
been a serial share repurchaser for many years now—it has reduced its
shares outstanding from 99.2 million in fiscal 1995 to 80.5 million in
fiscal 2000 and 70.8 million in fiscal 2005. It has also been a
flexible repurchaser. Buybacks reached $94 million in fiscal 2001 but
tumbled to just $19 million in fiscal 2002, a dreadful year for Herman
Miller and its industry. With the recovery in the company’s business,
repurchases jumped to $132 million in fiscal 2005, and the board
authorized another $150 million in January.
The procedure for authorizing repurchases is much the same at most
companies. First the CEO and the finance staff propose a repurchase
authorization as part of the financial plan for the year or years
ahead. The finance committee of the board reviews the entire plan—not
just the repurchases—and may suggest modifications in any part of it.
Then the plan goes to the full board. Directors often ask about
alternatives to the repurchase plan, such as increasing the regular
dividend or issuing a special dividend, but they rarely overrule the
decision reached by management and the finance committee.
Yet share repurchases do warrant close scrutiny by the board. A
frequent motivation behind repurchases—and one directors should be
leery of—is to boost earnings per share and return on equity. Most
finance executives say boosting (read: manipulating) earnings per share
is an important factor in their repurchase decisions. Share buybacks
will have that effect whenever a company’s per-share earnings are
higher as a percentage of the stock price than the after-tax cost of
borrowing to finance the buyback (or, in the case of companies
financing buybacks with cash rather than debt, the forgone after-tax
income generated by those cash reserves). With after-tax borrowing
costs for most corporations now at 5% or less, any company with an
earnings yield above 5% will get an artificial lift to both EPS and ROE
from a repurchase. Stated somewhat differently, EPS and ROE will both
go up if the company’s price-earnings ratio is below 20.
One wonders why managers would bother with this kind of manipulation,
since financial theory says it should not affect the value of the
shares beyond a very modest gain from the tax savings on new debt.
Everything else is just fiddling with the accounting arithmetic without
altering the underlying performance that determines the value of the
business. Yet the evidence from academic studies says they do try, and
as expected, it doesn’t work.
One such study was performed by Paul Hribar of Cornell, Nicole Thorne
Jenkins of Washington University in St. Louis, and W. Bruce Johnson of
the University of Iowa. They found, among other things, that a
disproportionately large number of companies do EPS-boosting
repurchases when they would otherwise marginally miss analysts’
earnings forecasts. The companies apparently believe that they can fool
Wall Street into thinking that they made their earnings numbers. In
fact, Hribar and company found that the market sees through the ruse,
with companies that meet or exceed earnings expectations solely because
of repurchases receiving a 60% lower valuation premium than companies
that get there without a repurchase.
Even though the increases in EPS and ROE that are driven by buybacks
are wholly cosmetic as far as the stock market is concerned, they can
have substantial payoffs for executives whose incentive compensation is
based on one or both measures. As a result, compensation committees
should make sure that they adjust the EPS and ROE targets used in
incentive plans to rid them of “improvements” caused by repurchases.
Another reason managers like repurchases is that they believe they can
tell when their shares are undervalued, and so can buy them in at
advantageous prices. Every company with a repurchase program uses
internal models to value the company and determine the ranges at which
it will and will not buy. Critics of repurchases (every corporate
activity has its critics) see this as a major problem. One is Jesse M.
Fried, co-director of the Center for Law, Business and the Economy at
the University of California at Berkeley. As he sees things, many
companies repurchase shares below their true value in order to transfer
wealth to managers, whose proportionate holdings in a company rise as
the number of shares outstanding is reduced. “There is no reason that
companies should be able to trade against their shareholders,” he says.
“There is no reason to treat corporate repurchases differently from the
managers’ own insider trading.” Fried’s arguments raise one big
question, however. If managers really believe that the stock is cheap,
why not just buy shares themselves? That way they get all the gain
instead of just a proportionate share from corporate buybacks.
Few others see repurchases as a significant governance issue. Nell
Minow, editor of the Corporate Library watchdog outfit, says the
subject has never come up on her radar screen. Charles Elson of the
University of Delaware, who is a director of AutoZone, a regular share
repurchaser, doesn’t see a problem either. “I have never viewed
repurchasing as gaming,” he says. “It benefits all shareholders.”Can
managers really tell when their shares are too cheap or too dear? Armed
with all the inside information they’re privy to, they certainly ought
to know when their shares are dramatically undervalued, and the
academic evidence clearly indicates that some managers can spot major
mispricing. But if managers were really omniscient traders, the stocks
of virtually all repurchasers ought to outperform the market. They
don’t. What’s more, the use of buybacks as the means to distribute
excess cash almost guarantees that repurchasers will be lousy market
timers. Remember that repurchases dropped with free cash flows in 2002,
when stocks were in the tank, and didn’t recover until after the stock
market rebounded in 2003.
