The Buyback Bust?
December 12 2008 by C.J. Prince
In late September, as the financial markets reeled from the Wall Street meltdown, General Electric revised its guidance downward and announced that it was suspending its stock buyback plan, citing “unprecedented weakness and volatility” in the financial markets. “We have made some tough decisions to further reduce risk and strengthen our balance sheet while maintaining our dividend,” GE chairman and CEO Jeff Immelt said in a statement. The company said its fundamentals were strong, that it was committed to its Triple-A credit rating, and that the buyback suspension would reduce GE Capital leverage and allow the company to pursue “opportunistic acquisitions.”
If Immelt was hoping to get credit for his honesty-most companies, under no obligation to complete a buyback, typically just let their programs peter out quietly when they’d rather not continue them-it was not to be. Predictably, GE’s stock sank 5 percent in premarket trading. True, the lowered full-year outlook probably didn’t excite investors. But, in general, over the last three years of the buyback boom, the media and analysts have been consistent in their black-and-white reception of buybacks: put simply, buybacks are good. If a company is purchasing its own shares (even if only as a way to offset dilution from the many stock options coming due), it must be a clear sign of free-flowing cash; a healthy capital structure; and overflowing coffers with plenty of cash reserves for possible lean times, so much so that it can afford to spend the excess returning value to shareholders. In fact, if a company has extra cash that it isn’t immediately investing in new plants or M&A, not starting a buyback could practically constitute shareholder abuse.
But the pendulum may be on its way back. Recent examples of financial firms voraciously gobbling up their own shares, only to run mortally short of cash, could dull the luster of buybacks. Take the now bankrupt Lehman Brothers. On the heels of aggressive buybacks in 2007, Lehman then spent an additional $765 million in the first quarter of 2008 repurchasing stock, at an average price of $59.05 a share.
After each buyback announcement, Wall Street nodded approvingly and the stock rebounded. But when the firm, not long after, realized it was cash-anemic, it sought to raise $8 billion through preferred and common stock offers and was forced to sell at prices far lower than that it had bought at. “If they could roll back the clock, I’m sure they would never have repurchased a single share just to have that extra resource,” says John Graham, an economist with
Still, Lehman’s persistent and aggressive buybacks late in the game have led some to question whether companies in distress have been using buybacks simply to make a dramatic show of management’s confidence while CEOs and CFOs scramble to come up with a sustainable recovery plan. “Their motivation wasn’t to make money, it was just to buy time,” says Marek Fuchs, a former stockbroker for Shearson Lehman Brothers who now covers finance for TheStreet.com. “When that’s your motivation in a buyback situation, you probably will succeed in buying yourself a little bit of time, but you’re going to lose money because the decision is made for all the wrong reasons.”
Lehman wasn’t the only firm that found at least temporary shelter under the buyback umbrella. In March of 2007, AIG’s stock, which had been sputtering, got a boost after it announced it would buy back up to $8 billion in shares. In May of last year, Merrill Lynch told Wall Street it would buy back as much as $6 billion of common stock, which came on the heels of a $5 billion authorization the previous October. Ultimately, of course, the buyouts did nothing for either company’s stock long-term. And recent data raise doubts about whether companies that have spent hundreds of millions, or billions, on buybacks have gotten the stock pick-me-up they’d hoped for. An 18-month S&P study published at the end of last year reported that only 25 percent of S&P 500 companies that repurchased shares during that time outperformed the index. That means the other three quarters might have earned a better return on their money had they invested in an S&P index ETF rather than their own shares.
There is no way to account for the potential return companies might have seen had they invested in other areas designed to increase revenue- new product development, R&D, marketing-in place of share repurchases. But it’s clear that buybacks have gotten a larger share of the budget. During the three years between fourth–quarter 2004 and third-quarter 2007, S&P companies spent $1.3 trillion repurchasing their own stock. That is slightly more than they spent on capital expenditures, more than triple the amount spent on corporate research and development, and more than double common- stock dividend payouts, according to S&P data. “That’s astonishing isn’t it?” remarks Lawrence E. Mitchell, business law professor and founding director of the Institute for International Corporate Governance & Accountability at the George Washington University Law School. “If what we’re concerned about is the efficient production of goods and services, then buybacks are disastrous.”
The hunger for buybacks was fueled in part by the buildup of excessive cash reserves on company balance sheets as CEOs and boards grew more risk-averse in the post-dot-com slowdown. Activist shareholders, growing antsy with the untapped piles of cash, began leaning heavily on corporate boards to return some of that money in the form of buybacks. The market liked the positive impact on earnings-per-share, the upward pressure on the stock and the cash-efficiency of the tool. Dividends, which had far outpaced buybacks in years prior to 2003, began to lag as the tool of choice because of the immediate capital gains hit and because they tended to limit companies’ options going forward. While buybacks can be done one-off, dividend programs are defined by their regularity. “If they fail to increase [their dividends], they might as well put up a sign that says ï¿½ï¿½liquidity problem’ on their front lawn,” says Howard Silverblatt, senior index analyst for S&P’s Index Services unit. GE, for one, certainly found it more palatable to suspend its buyback program than to cancel its dividend.
Share buybacks don’t require any future guarantees. In fact, a company can announce a major repurchase plan but then be under no legal obligation to complete it, which critics say is one of the problems. “There are a lot of games played there,” says Fuchs. “They’ll say, ï¿½ï¿½We’re going to do a billion- dollar buyback by 2009, and the media reports it and traders jump on it and the stock pops, but there’s no follow through.” Companies can then unveil another major repurchase plan well before the last commitment is fulfilled. According to the Web site The Online Investor, which tracks buyback activity, the majority of buybacks announced in September either extended a prior plan or added to a prior plan, while only 10 percent had completed their prior commitment.
Fuchs argues that Wall Street has been far too quick to assume a buyback is a sign of management’s confidence. “It indicates too many false positives,” he says, adding that investors confuse the action with insider buying, when CEOs put their own cash on the line. “A little bit of optimism isn’t unwarranted because it’s the float, the amount of shares, and that could have positive financial implications,” he adds. “But what really sticks in my teeth like a raspberry seed is the way it’s been taken as this definite positive. CEOs have really abused it as a tool, and the media at the top level just plays along dumbly.”
Recent numbers show companies are pulling back sharply on their buyback largesse. This past quarter, the S&P 500 collectively spent about $87.9 billion buying back their own shares, down from $157 billion last year-a 44.3 percent decline. That represents the lowest level since third quarter of 2005. “The financials have fallen off, and there are liquidity issues out there,” says Silverblatt. But he adds that buybacks still far exceed dividend payouts, and that with millions of options coming due this year and next, companies will still have reason to do repurchases.
Abuses and desperate moves aside, there are legitimate and strategically sound reasons for doing a buyback. The rising EPS does make the stock more attractive. And, if cash is sitting idle in company coffers, no legitimate other investments arise and management truly believes the stock is undervalued, it seems to make sense. Anders Gustafsson, CEO of Zebra Technologies, thought so. In February, Zebra completed a 3-million share buyback and the board decided to authorize the purchase of an additional 3 million shares, representing approximately 4.5 percent of Zebra stock outstanding at the time. “We felt we had a capital structure that allowed us to return some money to shareholders, substantial growth opportunities for the future and that it felt like our share price was the best investment opportunity on the Nasdaq,” says Gustafsson. The company has already spent $300 million on four strategic acquisitions and is now working on integration and synergies, so it doesn’t need to hoard cash to make a deal.
As far as getting a good deal on his own stock, Gustafsson says the company will be taking advantage of dips in the share price, buying low wherever possible. “So it doesn’t mean we will do the same volume every week,” he notes. Zebra’s stock has suffered some from the market distress, recently falling as low as $29, but Gustafsson remains confident that the company is well positioned for the downturn and that the stock is likely to climb back up into the $40s. He says that the company considered a dividend but shareholders with whom he consulted preferred the tax efficiency of the buyback. “It also allows us to take out some of the marginal investors who are not necessarily long-term investors in our stock. And it gives us the most flexibility going forward if something should change.”
Some companies have so much cash, they couldn’t possibly spend it all on areas of revenue growth. Take Microsoft, which in September unveiled a five-year, $40-billion stock repurchase plan-the single biggest buyback commitment announced this year. Graham notes that for mature companies like the
Or they might be tempted to make other ill-advised investments with the extra cash, says Dirk Djik, director of research for stock analysis firm Zacks Equity Research. “If I’m in a market where I’ve got a great plant and equipment that’s providing a huge return on investment, it doesn’t necessarily follow that putting up a second one is going to repeat that,” he says. For example, Djik points to U.S. Tobacco, which manufactures the Skoal smokeless tobacco product. “Their profits and margins are just insane. To build a second factory to produce more, you’re not going to get anywhere near those returns, so it doesn’t make sense to plow the money in.”Since the repurchased shares are typically not retired, they’ll still be available for the company to use in M&A or for reissue, which means buybacks are no assurance that the company won’t make foolish bets in the future. If recent events are any guide, investment in one’s own stock will no longer be considered the company’s safest bet. Even in the technology space, which now accounts for 26 percent of all buybacks, according to S&P, news of Microsoft’s enormous buyback commitment boosted its share price only 1 percent. Nike and Hewlett-Packard, which both announced new buyback plans in September, saw their shares drop immediately following. With any luck, a year from now, they and other buybackers won’t be wishing they had that cash back, burning a hole in the corporate pocket.