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With stock prices plummeting, why isn't Corporate America pumping up its repurchases?
Russ Banham, CFO Magazine
March 1, 2001
In December, the board of Alanco Technologies Inc. authorized the buyback of 500,000 common shares, or about 7 percent of its total shares outstanding. To CFO John Carlson, the action was more than appropriate. After all, the company had significant capital to fund the buyback--its fiscal first-quarter sales were $2.8 million, roughly its entire sales output in the previous annualized period. In addition, its stock price was getting no respect, having fallen from $6 a share in March 2000 to 81 cents a share on December 26, about a 75 percent drop in nine months.
"Some people believe the markets are these pure vehicles that always value every stock correctly," says Carlson. "I'm not among them."
While many finance executives would agree with Carlson's reasoning-- especially his belief that his stock is undervalued--not everyone is following his lead. Indeed, according to a study by Bridgewater Associates Inc., in the last six months of 2000, only $57 billion in repurchased stock was recorded, a far cry from the $144 billion recorded in the last six months of 1998. And while the buyback frenzy is far from over, it may be taking a breather.
The conundrum, of course, is that the time to buy back stock is when share price is low. And this, it seems, is one of those times, given recent declines in the S&P 500. Yet, the economic conditions that often prevail at such times--lower sales, less cash, and tighter credit scenarios--seem to be having "a deleterious effect on stock buyback activity," explains Greg Jensen, senior research associate at Bridgewater, a Westport, Connecticut-based money management firm. In addition, numerous companies, such as Hewlett-Packard, Microsoft, and AT&T, which made huge investments in their own stock in recent years, only to see the stock prices plummet, are suffering from a bad case of indigestion.
Little wonder that finance executives who are entering the buyback market are being more diligent than ever--despite the much-ballyhooed promise of a stock price boost and the management confidence it signals. "Someone has to make the decision about how much the company wants to be on the hook at a given time," says Frederic Escherich, a managing director in the mergers and acquisitions group at J.P. Morgan in New York. "And that job often is the CFO's."
ONE MEAN HANGOVER
Historically, the adage that firms buy back when stock prices are low has held fast. The morning after the Black Monday crash of 1987, for example, "more than 700 repurchase programs were announced in the press," notes David Ikenberry, a professor of finance at Rice University. Likewise, buyback activity peaked in 1998, when stock prices faltered due to the residual effects of the Asian financial flu.
"It's almost always the case that when the stock market plunges, buybacks come out of the woodwork," says Ikenberry. "But I don't think the current malaise is a catastrophe on the order of Black Monday." Nor are the circumstances similar to the peak year, says Jensen. In 1998, he says, "liquidity was extremely good. This time around, however, companies don't have the cash flow to avail themselves [of a stock buyback]."
One reason why cash is in short supply, of course, is that in addition to going on an acquisition binge during the past few years, corporations have invested heavily in their own stock. Hewlett-Packard, for example, spent more than $8 billion from November 1998 to October 2000 to buy back about 128 million of its shares. Today, those shares are worth about half that amount. The situation is similar at Microsoft, Intel, and AT&T, where much-heralded buyback programs are now being criticized because the total value of company shares has fallen more than $1 billion over the past two years. To make matters worse, many companies borrowed heavily to fund the buybacks, contributing to some of the 45 credit-rating reductions in 2000, according to Moody's Investors Service.
The companies themselves offer no apologies. "We regularly purchase our own stock, determining through a set of metrics what we think the price of our stock should be," explains a spokesperson for HP. "If it looks like the low end of that range, we tend to buy more stock; at the high end, we buy less." The metrics are proprietary, he adds.
Still, says Ikenberry, it's fair to say that last year the market had an overinflated view of stocks' worth, influenced, no doubt, by what investors were willing to pay. On the other hand, Escherich says, "nobody buys high on purpose. And while some companies may not buy, because they believe their stock is overvalued, you're never going to read about that. You only read about the buybacks that look ill- advised a year later."
For years, buybacks have seemed not only smart, but also routine. The theory goes, says Escherich, that whether one buys high or low, it all averages out. Some firms, for example, "are pretty steady buyers, paying both high prices and low. In effect, they are buying at average prices over time, never really making or losing money." In addition, he says, buybacks have always been more than just a "buy when the price is low" strategy. Indeed, a recent study conducted by San Diego State University professors S.G. Badrinath and N. Varaiyat for the Financial Executives Research Foundation, cited five basic reasons to repurchase: to boost stock price, to rationalize the company's capital structure, to substitute for cash dividends, to prevent dilution from stock option grants, and to give excess cash back to stockholders.
And despite recent market malaise, some finance executives believe those reasons are as valid as ever. At Cypress Semiconductor Corp., for example, CFO Manny Hernandez is very methodical about determining a market misprice, extrapolating it from the price-to-sales ratio. "We've been trending these metrics since 1986," when the $1.3 billion San Jose, California-based technology- solutions firm went public, he says.
"Our mean ratio over this period (198698) is 2.23, meaning that 2.23 times sales is our market cap on average," explains Hernandez. "Our P/S ratio in our 90th percentile band is 3.46, and in our 10th percentile band it's 1.43. When our P/S falls below 2.23 and veers toward the 10th percentile, that indicates our stock is undervalued. That's when we tend to buy it back."
In the future, Cypress expects its mean price-to-sales ratio to move up as a result of the company's focus on high-growth markets, namely datacommunications and telecommunications, says Hernandez. While the semiconductor industry grew 31 percent last year, Cypress's sales in its last fiscal year jumped 81 percent, largely based on sales in the datacommunications and telecommunications markets. "This outlook has given us the comfort to buy back our stock at a P/S of 2.3 or lower," he says. In the fourth quarter of 2000, Cypress's board announced the repurchase of 10 million shares overall, of which about 80 percent had been bought as of January.
At Ciber Inc., justifying a buyback comes down to an investment decision. David Durham, CFO of the $600 million computer services integrator, runs two test cases to determine whether to buy back stock or to invest in a money-market fund--"with the financial question being, 'which is better for our earnings per share?'" he says.
Basically, Durham takes into consideration the difference in total net income between investing excess cash in a money-market fund, which incurs a 40 percent tax hit, and buying back stock. And based on that evaluation, Ciber announced a $5.9 million buyback in June 1999, of which 4.6 million shares had been repurchased by the end of December. "In the December 2000 quarter," he explains, "we reacquired 1.4 million shares, which increased our EPS by .19 cents--4 percent more than would have been the case had we not repurchased them and left the cash instead in investments."
Of course, growing companies such as Alanco admit to using more subjective criteria to justify a buyback. "Emerging companies don't have a history of earnings, [so they don't] know what their P/E is," explains Carlson. "Unlike mature companies that can use a matrix based on these metrics [to gauge stock undervaluation], we must rely more on a subjective assessment of our potential versus our competitors'. If this analysis tells us we're being undervalued, it enhances the prospects of a buyback."
OUT OF OPTIONS
If such gut instinct came into play at companies that issued buybacks to offset options last year, it obviously wasn't a surefire metric. Ironically, though, the low valuations being assessed by Wall Street may be a reason buyback activity has slowed. "When stock prices are low, the exercise of stock options is also low, thus moderating the need to neutralize them via a share repurchase," explains Escherich.
That's not to say that some companies aren't still using buybacks to offset options. NCR Corp., for example, announced a program to repurchase $88 million of its stock in fourth-quarter 2000 to fund outstanding employee stock purchase plans, including stock options. "This is an open authorization, meaning we can choose to go in and buy or not to," explains CFO David Bearman. And Bearman fully expects to go in based on "an analysis of what we think the stock price will be at some later date."
Few can argue with his track record. NCR announced two major stock repurchases prior to 2000: a $250 million buyback in early 1999 that was completed, and a $250 million buyback later that year, of which $70 million to date has been purchased. Both were predicated on expectations of higher share price. "We made the first repurchase when our stock was in the mid-30s, and as of today, we're at $45 a share," says Bearman.
Can any lessons be gleaned from buybacks that have backfired? "It is difficult to guard against buying stock that later devalues," acknowledges Bearman. In making buyback decisions, he says, "we look to the future in terms of expected progress. In other words, you don't second-guess yourself on what went down this year, because next year it might go up."
As the NCR announcement illustrates, there are plenty of companies that still believe this may be their year. In January, for example, the newly formed AOL Time Warner Inc. announced a $5 billion stock buyback program that began last month. In addition, 47 other companies, according to Securities Data, announced repurchases, including Newport News Ship Building Inc. and MAF Bancorp.
Says Ikenberry, "There are fundamentally sound reasons for companies to buy back stock." And while buyback activity may "ebb and flow" depending on economic circumstances, "it is absolutely not going away. Let this bear market run a bit longer, and then see where we stand."
Russ Banham is a contributing editor of CFO.