Share buybacks are surging. But does the trend add up for shareholders?
Companies spending heavily to repurchase a portion of their shares typically draw praise from stockholders and Wall Street analysts. That’s because large-scale buybacks frequently jump-start a company’s dormant stock.
Buybacks “are the new trend in corporate America,” said Standard & Poor’s Corp. senior analyst Howard Silverblatt. Among the companies in the S&P 500, he said, company outlays for buybacks jumped 69 percent last year, to $334 billion.
Still, not everybody considers buybacks the best way to deliver long-term value. Bondholders, who prefer companies that keep a robust financial profile, tend to be particularly dubious about big share-repurchase programs.
But experts say equity investors also need to be aware of potential drawbacks.
The debate has sharpened of late, as firms like Kerr-McGee Corp. and Time Warner Inc. have found that multibillion-dollar buybacks can provide a relatively painless way to placate activist investors who demand that management “unlock shareholder value.”
One reason buybacks have come to the fore in recent years is the fact that U.S. corporations have seen such a huge increase in their cash position.
The reasons for the cash buildup are complex. The economy has rebounded, of course, but that’s not necessarily the key.
Earnings have soared, and some observers think the bursting in 2000 of the dot-com bubble, and the overinvestment that accompanied the bubble, has made many companies, particularly those in the high-tech and telecom sectors, ultracautious about investing in new capacity.
And the rise of Asia as a manufacturing powerhouse has put a chill on many U.S. producers’ expansion plans, either here or abroad.
Having extra cash is better than having too little, of course, but it still creates a bit of a quandary: Should the money be plowed back into the business or returned to stockholders? And if it goes to stockholders, should it be done through a dividend or a share buyback?
For early-stage companies, the first question is a no-brainer. Young companies typically use whatever cash they can scare up to hire additional workers, buy equipment, fund product research or pay for brick-and-mortar expansion.
Other growth-minded companies use their cash to make acquisitions, seeking economies of scale and access to new markets or technology.
Many critics say companies that engage in buybacks are simply lacking better ideas to spend their cash.
But for many U.S. firms operating in mature markets, wide-open growth is no longer a smart strategy, and meaningful acquisition opportunities show up only occasionally. Those companies may decide to pay some of their growing cash hoard back to stockholders.
The most direct way to do that is through a cash dividend, either at regular intervals or as a one-time special payout.
The other way to return value to investors is indirectly, by buying back some shares. Reducing the number of shares outstanding makes the remaining stock worth more, because the value of the company is divided among fewer shares.
In recent years, the amount of money spent on share repurchase plans has climbed much more dramatically than that spent on dividends, both on a percentage basis and in actual dollars.
There’s disagreement over why corporations are favoring buybacks, and whether the preference makes sense.
One obvious reason buybacks are popular can be traced back to U.S. corporations’ love affair with stock options in the 1990s: Years later, as recipients exercise their options to buy shares from their employer at a discount, existing holders’ stakes are diluted. By mopping up such shares, buybacks can help firms rein in such dilution.
But some observers say companies should buy their own shares back only when there are no better investments, and even then only when the stock is cheap. Many investors see buybacks as a sign that company management thinks the shares are undervalued.
But some firms buy back their shares at prices high and low; they sometimes borrow to finance it, and they buy back so much of their stock that the number of shares outstanding declines. That boosts earnings per share, Wall Street’s favorite tool for measuring profit.
Low-risk option
It’s not the boldest move, however.
“A stock buyback is a risk-free way of ensuring earnings accretions,” said Carol Levenson, an analyst with the bond analysis firm Gimme Credit. “As long as borrowed funds remain cheap, as they have for some time, it’s also an inexpensive way to boost one’s earnings per share.”
In contrast, Levenson said, “investing in the business, buying another company or other uses of cash carry considerable risk, naturally.”
Bondholders don’t receive any benefit when a company buys back its shares, and Levenson’s perspective is on whether a buyback may degrade a company’s fiscal health.
“Buybacks that are executed over a period of time and are funded with the company’s free cash flow aren’t harmful to an issuer’s credit quality,” she said, “although they certainly don’t enhance it.”
To the extent such restrained buybacks keep the stock price healthy, they do improve a company’s financial flexibility, she said, “and that’s always a good thing.”
But buybacks that employ borrowed funds and are executed all at once, she said, “can dramatically increase the company’s financial risk. And, of course, once that money is out the door, it’s gone forever; if business conditions should change suddenly, the cash spent on a stock buyback might come in handy.”
Still, Levenson said, if forced to choose the “lesser of two evils” between a gradual stock buyback funded with free cash or a material dividend increase or special dividend, bondholders would choose the buyback. If the company’s situation changes, and cash becomes tighter, she noted, “it’s tougher to ease back on the dividend throttle than it is to slow or stop a stock buyback.”
For other experts, the dividend’s attraction lies in the discipline it imposes.
Weighing the choices
Patrick Dorsey, director of stock analysis at Morningstar Inc., is among that group.
Dorsey isn’t opposed to buybacks by companies in a mature business with few profitable internal investment opportunities, saying a repurchase plan makes more sense than chasing growth. But a dividend is “absolutely” superior to a buyback, he said.
“A dividend is useful to me as a shareholder regardless of the price of the stock,” he said. “But if you buy back stock that’s overpriced, that’s a bad investment” of the company’s cash.
To the extent that companies focus on reducing the dilution caused by options, he said, they’re not paying attention to the value of the shares they’re buying back.
“If I announce a dividend, I can’t take that back,” he said. “I can’t cut the dividend without the market reacting.”
In contrast, he noted, buybacks can be halted, without any public announcement, at any point.
And that could be a problem.
“Corporate managers want to sound shareholder friendly,” he said, and a buyback plan allows them to do that. But unlike a dividend plan, with a buyback “if they find something else they want to do with the cash–like a dumb acquisition–they can do it.”
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Market reactions
Companies often see their stock rise the day they announce sizable repurchase programs. Here are some notable examples:
%% Company Announcement Amount Stock
Merrill Lynch February ’06 $6 billion +1.5%
Intel November ’05 $25 billion +1.8%
Kerr-McGee April ’05 $4 billion +6.7%
Dell March ’05 $10 billion +2.2%
Microsoft July ’04 $30 billion +1.9%
Source: Tribune research
Chicago Tribune
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