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Does the rise in share repurchases reflect optimism about the future, or a lack of alternatives?
Vincent Ryan, CFO.com | US
March 24, 2010
While many CFOs are still casting a cold eye on spending requests for R&D, training, equipment, and hiring, some are warming once again to the idea of returning value directly to shareholders. Bloated with cash — S&P 500 companies had $820 billion of cash and cash equivalents on their balance sheets at the end of the third quarter of 2009 — publicly held companies are returning to the stock market to repurchase hundreds of billions of dollars of shares.
The quarterly dollar volume of buybacks plummeted a year ago, in the first quarter of 2009, to $12.3 billion, according to data supplied by Dealogic (see chart below). But the fourth quarter of 2009 saw a rebound, with dollar volume hitting $170 billion. Thus far this quarter, $97.9 billion of buybacks have been announced. Limited Brands, Phillip Morris, Lowe's, Colgate-Palmolive, Amazon.com, and WellPoint are among the companies that have announced large buyback programs. The biggest announced this year is that of PepsiCo, which pledged to buy $15 billion of its shares by June 2013.
Why are companies returning cash to shareholders so soon after big declines in revenue and profitability just one year ago? It's a signal, first of all, that "many companies are breathing a partial sigh of relief that the worst of the recession is over," says Francois Mallette, head of the private-equity practice at L.E.K. Consulting, a shareholder consulting services firm. There's been a "thawing" in C-suite attitudes about the economic turnaround and the credit markets, notes Mallette. "They have faith in operating cash flows, and to some degree the credit markets have revived. That gives them the feeling that they can go out and do a buyback," he says.
But many companies are struggling with the decision whether to repurchase stock, adds Mallette. The intrinsic value of a company — used to determine if the company is undervalued by the market — is not easily measured, and board members often enter the discussion with preconceived notions about whether buybacks are worth anything. The executive management of companies that have announced buybacks thus far in 2010 deserve kudos for fighting through some of those issues and having some foresight, says Mallette.
After all, buybacks earn companies a very good relative return compared with other capital investments, and can do it relatively swiftly. The increase in earnings per share can signal to investors that the stock is undervalued, and a decrease in the number of shares outstanding can help propel the stock price upward. A buyback also increases a company's leverage, whether it uses cash or debt to repurchase the shares. "The right amount of leverage is value-creating," says Mallette.
But a buyback can also indicate pessimism on the part of executive management and the board. "It might be viewed as a negative for a high-growth company: it might say to investors that the company doesn't have any project or activities that can achieve higher returns [than a buyback]," says Jeff Mahoney, general counsel at the Council of Institutional Investors.
"I think [a buyback has] become the easy way out," says Gregory Milano, CEO of Fortuna Advisors, a value-based strategy adviser. "A company can get earnings per share accretion with certainty, whereas if they invest in R&D, there is a lot less certainty to whether it will pay off." In an analysis of buybacks over a five-year period ending in 2008, Fortuna found that companies that put more money into buybacks had lower total shareholder returns (dividends plus capital gains).
That said, if a company has really run out of ideas for deploying capital, or isn't in a growth business, or can't cover its cost of capital, a buyback can make sense. Still, many companies would be better served by putting money back into the business, argues Milano.
How big a pop issuers are going to get from buyback programs is another question. As of Tuesday, the share prices of the buyback companies cited above, except for Amazon.com, were within dollars or cents of their 52-week highs. The S&P 500 Index is up 42% from exactly one year ago, and its collective P/E ratio is 22.9%. All this suggests that it could be difficult for buybacks to move stocks much higher.
Taking into account only share price, "six to nine months ago would have been a better time to do [a buyback], but companies had zero confidence in their cash flows then," says Mallette. Indeed, companies tend to buy back a lot more stock when their share prices are high than when they are low, he says, evidenced by the half a trillion dollars in shares companies bought back in 2007, when markets peaked. "It's just like M&A: when we feel good about the world, we're willing to spend money," says Milano.
Still, companies don't need pinpoint timing when announcing a stock buyback, since programs usually involve repurchasing stock over a period of one or two years, or even longer. More important than timing is to get shareholders to understand and buy into the thought process behind a buyback, says Mallette. "It's important for a company's financial strategy to be judicious," he says. "If you do it right and consistently, the market will understand that. That buys you more value."