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A raft of companies have recently announced plans to repurchase their stock. This may not be such a hot idea.
Jennifer Caplan, CFO.com | US
September 20, 2002
Call it buyback mania.
With the price of equities plummeting -- and with it, investor confidence -- corporations have started repurchasing stock at a dizzying pace. According to Trim Tabs, a company that specializes in tracking and analyzing market liquidity, publicly traded companies so far this year have bought back at least $30 billion worth of stock.
Last month alone, more than 100 companies, including Merck, PepsiCo, Citigroup, and Home Depot, initiated programs to buy back over $43 billion in stock. That makes July the biggest month for buyback announcements since last September, when corporates launched $54 billion in buyback programs following the 9/11 terrorist attacks.
The September numbers were not surprising. Companies often buy back stock during times of crisis and equity downdrafts. After the stock market swoon in October 1987, for example, a staggering 777 publicly traded companies announced repurchase programs. The slew of corporate buybacks helped spark a stock market rally, boosting the Dow Jones Industrial Average by 11.5 percent by year-end.
Likewise, in the three weeks after Sept. 11, 131 companies said they would buy back at least 5 million of their own shares. The repurchases fueled a minor recovery on the major U.S. exchanges.
In fact, many finance executives believe repurchase programs send a clear signal that a company's stock is undervalued. By scooping up outstanding scrip, they say a company is able to steady the nerves of jittery shareholders. What's more, a buyback reduces the supply of shares on the open market. That, buyback backers say, eventually drives the price of a company's stock up.
And in fact, a study conducted by Prudential Securities analyst Ed Keon would seem to bear this out. Keon looked at all the companies that conducted buybacks from 1984 through the second quarter of 2001. He found that corporations that reduced their outstanding shares by at least 1 percent generated greater annualized stock returns than the S&P 500 index.
But some critics say an open-market buyback is not the slam-dunk it might appear to be. In an open-market buyback, a company pledges to repurchase shares over a period of time at the prevailing market price.
And that's the rub. Purchasing a stock at the current trading price -- rather than at a premium -- can give the impression that the market valuation of a company's stock is pretty much spot on.
Just getting the market to notice a buyback plan can be tough these days. Al Ehrbar, senior vice president at consultancy Stern Stewart, believes many investors have started to ignore open-market repurchase plans. Why the cold-shoulder? Because companies have routinely failed to follow through on their announced plans -- or have taken forever and a day to complete the buybacks.
"It's a much more persuasive communication to the market to buy back shares all at once through a Dutch auction or fixed-price tender offer," Ehrbar contends.
In fact, some market-watchers say open-share buyback announcements are sometimes seen as red flags by the investment community. "It may be alarming to the market that a company sees no expansion opportunities out there," explains Bob Willens, a tax and accounting expert at Lehman Brothers. "It can be a sign that a company can't find anything better to do with its cash."
What a lot of companies did with their cash in the go-go Nineties was buy back equity, then funnel the shares into generous employee stock option plans (ESOPs). The theory behind all the repurchasing: aligning workers' interests with that of shareholders would spur productivity and performance.
A worthwhile goal. But in reality, ESOP-driven buybacks programs have a nasty habit of backfiring. As Willens points out, companies in the Nineties usually repurchased their shares at market prices. Employees, however, typically bought shares for substantially less under their ESOPs. Thus, employers not only took a loss on the deal, they essentially blunted the whole purpose of the repurchase program -- to boost share prices.
In some case, employees exercised so many options that the total number of shares outstanding remained unchanged. In a few instances, ESOP-related buyback programs actually increased the number of shares on the open market, ultimately lowering a company's earnings per share.
Buyback proponents say the greater the percentage of shares a company retires the better that company's stock generally does. For a buyback program to be most effective, they claim a company needs to reduce the number of shares outstanding by at least 3 percent over the previous year.
But large repurchase programs require a whole lot of capital. Critics of buybacks contend that companies can put their cash to better use. They also point out that investors are more likely to reward a company that attempts to grow it business -- rather than artificially inflate its stock price.
That's particularly true for companies in high-growth sectors. Dan Buddington, an analyst at Stern Stewart, says portfolio managers are more likely to embrace -- or at least overlook -- buyback programs launched by old-line businesses. "There are simply less investment opportunities to be had in mature industries," he explains, "Investors are more accepting of that."
But even blue chip corporates can set off alarms with a hastily conceived repurchase program. Such plans often tip investors that corporate managers have an unhealthy obsession with stock market and economic conditions, rather than building long-term value. Notes Willens: "Buy-backs are frequently one-off, ad hoc reactions."
This is not to say buyback programs are always a bad idea.
When the ROI in a share repurchase program exceeds that of returns on capital projects, for example, funneling cash back to shareholders can be a smart play.
Buy-backs are not a one-size fits all proposition, however. Many analysts and academics say the success of a buyback programs depends largely on the consistency and reliability of a company's earnings.
Certainly, executives considering a buyback better have a pretty good idea what their company's earnings will be over an extended period of time. The more predictable those earnings are, the less risky it becomes to shuttle cash back to shareholders.
James Gentry, a finance professor at the University of Illinois (Champaign-Urbana), maintains that a company's discretionary cash flow -- not operating cash, mind you -- should be high enough to sustain a repurchase. Gentry defines discretionary cash flow as operating cash flow minus working capital, interest payments and dividends.
Ironically, he says companies tend to launch repurchase programs in times of crisis, when earnings soften and cash flow wanes. "As operating cash flow goes down, capital investment usually falls off," notes Gentry. "That makes it more difficult to go through with a buy-back."
When a fair number of companies begin reneging on their stated intention to buy-back shares, investors start to become inured to buyback announcements.
In essence, the novelty wears off.
Delicate, Very Delicate
If follow-through is crucial to the success of stock buybacks, so too is how a company pays for a repurchase program. Corporate finance executives often choose to borrow to repurchase shares because the coupon on the debt is tax deductible.
But if debt servicing starts to interfere with a company's ability to generate consistent earnings and cash flow, a much-trumpeted buyback program can quickly start to resemble a millstone.
Not surprisingly, some bankers and analysts say debt-funded buyback programs are often a delicate affair. "Raising debt as a proportion of total capital is always dangerous," stresses Lehman's Willens. "It is precarious to have a high debt-to-cap ratio because there is no guarantee that the business will generate enough cash flow to service debt down the road."
The danger-level varies according to the industry a business operates in. Companies in the consumer non-durable sector, for example, can sustain a higher debt-capital ratio because earnings in those industries tend to be more linear. "In those cases," asserts Willens, "it wouldn't be alarming to see debt-capital ratios in the neighborhood of 40 to 50 percent."
On the other hand, managers at more cyclical businesses might be ill-advised to borrow money to fund a repurchase plan. Prudential's Keon maintains that, based on historical patterns, buybacks may not be as effective for large-cap companies with a debt-to-capital ratio substantially over 50 percent.
Ultimately, a corporation's bond rating may suffer if a buyback program raises the company's debt-to-capital ratio high enough. If a company's credit rating sinks low enough, thus jacking up borrowing costs, the positive impact of a buyback on earnings per share can be canceled out.
Even managers at cash-rich corporations need to think long and hard about stock repurchase program.
To show true faith in a company's future prospects, some analysts say a repurchaser should make a tender offer for the shares, rather than an open-market repurchase. In a tender offer, the repurchaser agrees to buy all the shares in a buyback program very quickly -- usually within twenty days. What's more, the buyback is usually at a considerable premium to the trading price of a stock.
Not surprisingly, tender offers tend to produce more of a wallop than open-market buybacks. "The stock price reaction will be higher with tender offers than open market repurchases," Buddington of Stern Stewart says.
According to Buddington, studies indicate that a company's stock price jumps an average of about 4 percent after the announcement of open market repurchase. And the stock run up after a tender offer? Share prices rise as much as 16 percent after such an offer is announced, Buddington asserts. Announcements of tender offers that are financed with debt have triggered stock price increases as high as 22 percent.
But tender offers come with their own set of risks. The biggest worry: the fixed premium in a tender offer might actually turn out to be higher than the average premium paid over time in an open market repurchase. Hence, repurchasers have to be spot-on accurate in their market forecasts. "There is definitely an element of market timing to buy-backs," notes Lehman Brothers' Willens.
Of course, recent launchers of open-market buyback programs like PepsiCo and Home Depot could get beat up by market events as well. Says David Bonaccorso, an associate at Hoefer & Arnett, a stock brokerage and investment bank based in San Francisco: "Companies may be paying too much for their shares, even though they now appear to be at very attractive levels."
Indeed, if the current stock market slide turns into a protracted slump, very few open-market buybacks will look like good deals for shareholders. "If the market settles at 15 and you bought back at 20," notes Bonaccorso, "then you'll have a bit of egg on your face when its all said and done."