Information Arbitrage to the NYT on Share Buybacks: Analytical Rigor Required

After picking up today's New York Times Business Section, a story immediately caught my eye: Why Buybacks Aren't Always Good News, by Gretchen Morgenson. Now this is a topic of more than passing interest to me, having been both an M&A banker and an equity derivatives specialist much of my career. But after reading the story I have to admit I was left a bit flat, and found myself asking the following question: was this intended to be an editorial with a discrete agenda or a story with the fact presented without bias? Because I have to tell you, this is a very complex, textured issue, of which little complexity or texture was introduced into the piece. So, for purposes of catharsis, I will note down a few of the more salient points here.

1. Buybacks don't always increase EPS

Huh? Don't they increase EPS, by definition, because there are fewer shares in the denominator of the EPS calculation? Isn't this the whole point? Answer: NO. There are two ways to look at a share buyback - from a corporate finance perspective and a GAAP earnings perspective. From a corporate finance perspective, the cost of a share buyback (purchasing an asset with the riskiness of your own stock) should properly be reflected as your cost of equity. But forget about this for a moment - we are focusing on EPS. From a GAAP perspective (the one that matters for EPS purposes), the impact of a share buyback is one of two things, either: (1) the opportunity cost of excess cash you are using to buy the shares (therefore your after-tax return on cash); or (2) the cost of debt used to finance the purchase (therefore your after-tax cost of debt). So, depending on your after-tax return on cash/cost of debt relative to your net margin, share buybacks may be either anti-dilutive or dilutive. I am so sick of the throw-away line "Share buybacks inflate EPS" - because it just isn't true. Whenever I read this in an article the credibility of the piece drops precipitously. This from the story:

Many investors applaud the buyback binge, considering these programs entirely beneficial. After all, buybacks support a company’s stock price and buoy per-share earnings by reducing the amount of stock outstanding.

Sorry, wrong.

2. Using cash and synthetic share buybacks to manage stock option exposure is prudent corporate finance policy

And the story goes on to say:

But less obvious to investors are the downsides associated with buybacks. By artificially inflating a company’s earnings per share, repurchases can mask business slowdowns, for example. Companies can hurt their financial positions by putting scarce cash into repurchases. And when buybacks are used to offset multitudinous stock option grants to corporate executives, an even more pernicious outcome can occur: the purchases may actually destroy shareholder value by forcing companies to essentially buy stock in the open market at high prices to cover shares sold at lower prices to executives.

Ok, so we've already seen one egregious factual error by stating as a truism that share buybacks "artifically inflate" EPS.  And then we see that "repurchases can mask business slowdowns" - I guess if one doesn't read financial statements, read the MD&A in the 10-K and 10-Q and lives in a cave this might be true. And yes, if a company who is ill-equipped to fund repurchases undertakes them it could potentially increase the likelihood of financial distress. But the coup de grace is the stock option example. Let's discuss the nature of option plans, for a moment.

Regardless of what tech CEOs might want you to believe (and have vigorously argued in front of and lobbied the Financial Accounting Standards Board and Congress), stock options cost real money and have a real value. But the positioning of this story is both ludicrous and false. Companies grant options as a form of compensation. They cost money. The cost is eventually crystallized when options are exercised and stock is sold at below-market prices. The difference between the cost of the stock at exercise and the strike price, after-tax, is the cost of the option to the firm. Now this cost could have been paid in cash or paid in stock. The nature of the currency really doesn't matter, as the author of this story would have you believe. Options aren't just a transfer of value from company to employee without getting something in return - the company gets the service of the employee. This creates value for all shareholders. 

Companies generally have two distinct policies for addressing the future dilution (read: crystallizing the cost of the options) arising from stock option grants: (1) entering into derivative strategies to participate in the upside participation of the stock in the future without consuming cash today; or (2) using open market stock buyback programs to reduce the amount of outstanding shares, over time, to offset the impact of option exercises. Either one of these strategies are prudent ways of managing this cost which is real yet whose amount is not precisely known at the time of grant. But the article really serves as an indictment of stock option programs, in general, which is just ridiculous. Either that or the person doing the writing has no idea what they are talking about, which I'll assume is not the case.

3. Rating agencies are sometimes out of touch with the real world

And the story goes on. Now an analyst from S&P chimes in, and doesn't really serve to enhance the analytical rigor of the discussion.

Clearly, not all buybacks are created equal — at least for investors. And as the numbers of buybacks grow, the manner in which they may mask a company’s true performance becomes more problematic.

“We have a concern here that investors may not appreciate the full impact that the buyback has on the earnings per share,” said Howard Silverblatt, senior index analyst at S.& P. “When the buybacks stop, where is the growth going to come from?”

Adding to the anxiety about repurchases, Mr. Silverblatt said, is the fact that the shares have not been completely retired. The company can bring them back onto the market at any point; this would dilute existing shareholders’ stakes.

“What is the company going to be doing with these shares?” he asked. “It is an enormous amount of assets under control of management that has not been retired and could be put back into the market.” Using cash to pay dividends would be far preferable, of course, especially given the lower tax rates that apply to such payments. But managements are wary of dividends because, once they grant them, shareholders come to expect them.

Howard, are you kidding me? It is not rocket science to figure out the imapact of a share buyback on EPS. If you have a financial model it should take you about 30 seconds. So who are you worried about? Widows and orphans, sell-side analysts, institutional investors or hedge fund managers? Nobody here is fooled, Howard. So chill out. "When the buybacks stop, where is the growth going to come from?" From operations or M&A deals, Howard. Where else? And those buybacks may not have been the driver of EPS growth in the first place - you've got to run the numbers, pal.

And the point about the shares not being retired and "The company can bring them back onto the market at any point; this would dilute existing shareholders’ stakes." This is called a secondary offering. Large companies seldom do them. Small companies frequently do, and there are things called filing requirements. Nobody is going to be blindsided. Whether or not the shares are in Treasury or newly issued is neither here nor there; the Board can authorize new shares to be issued if Treasury shares are not sufficient to cover the planned offering. So your whole point about this being an issue of information asymmetry is absoutely fallacious.

You are right about dividend policy - it is much less flexible than buyback policy for reasons of signaling. But that is a mighty small point in the sea of other stuff you said, in which you are I are in heated disagreement.

4. There are many legitimate reasons (and reasons for concern) for buybacks, precious few of which were mentioned in this article

Buyback programs look great from a distance. Up close, however, the picture blurs. More significantly, they may be a way for some corporate managers to think, once again, of themselves first and their owners second.

This is called an agenda. The data of the study that was frequently cited seemed neither compelling nor damning to me, and because a foundation of core understanding of buybacks was not established the article to me was a total loss. FYI, buybacks are frequently used to maximize the value of the firm, seeking an optimal balance between debt and equity given the riskiness of the firm's business today and in the future. And yes, while there are certainly Boards and managements that are culpable when putting GAAP (as opposed to value) based compensation plans in place, this is getting harder and harder as SarBox and other regulations are tightenend to further clarify the fiduciary responsibilities associated with compensation schemes. Therefore, I can't get too worked up about this stuff. What I do get worked up about is reporting that is not really reporting but editorializing. This should be carried in the editorial pages. This is called opinion, not news.

Comments

[Chris]

Roger, I am an MBA student working on an assignment regarding share repurchases and their effect on EPS. I have my own opinion on this but I obviously do not have your background. Therefore, if you don't mind, I would like your opinion on share repurchases in companies that have posted negative free cash flow for the past 2-3 years after share repurchases. In one article I am reading, the author is critical of these organizations and the bonuses their CEO's have been receiving. Inspite of the reported EPS being slightly higher (in most cases only 2-5%), nearly all of the companies reported on show EPS growth even without the repurchases. My second question is based on the relevance of an average increase in EPS of what seems like a minimal 3%. Is this really significant? And, why do companies want to issue debt to repurchase shares?

Thanks for your time and expert opinion in this matter. I really appreciate.

Regards,

Chris

[Bill a.k.a. NO DooDahs!]

"Wildly cynical dude." I like it.

Clarification: I didn't say that "buybacks are stupid all the time" – I said that I was negative on buybacks, expressed the opinion that cash should be deployed through operations or returned to shareholders rather than given to sharesellers, and stated that my personal case studies have not yielded a buyback that I, as a prospective investor, would have approved of.

Focusing on the philosophical point, a company taking cash on hand and giving it to those that sell the stock is effectively shooting the finger at those who hold the stock – they don't get any of that cash, do they? So I, the shareholder, go from holding a stock with $5 per share in cash, to holding a stock with no cash and a bunch of debt? OK. Meanwhile, the sellers of the stock get the full current price of the stock in cash. Last I checked, the responsibility of management was to the shareholders not the sharesellers.

From my limited experience in the real world, I find it hard to believe that more than a tiny fraction of firms have management and governance that consistently acts to maximize firm value more than they act out of political expedience and self-interest. Those firms probably exist; rare creatures, like the dodo bird.

Hypothetically! You say "Alternatively, if I am both over-capitalized and under-leveraged, why not borrow money cheap, take on a prudent level of debt, get a corporate tax deduction and give my shareholders the opportunity for a long-term capital gain?" From your earlier statement, it seems that an over-capitalized firm might be the result of a "lack of attractive growth opportunities" – if so, why then does increasing the leverage help the situation? We've already determined they can't grow. A dividend is a gain for the shareholders, isn't it? Any amount of cash that can significantly restructure the company's leverage profile is an amount of cash that could provide both capital gains and dividend payouts if used as a dividend increase or special dividend.

Maybe there's a buyback out there that I'll be able to look at and say, "hey, good idea!" But I haven't seen it yet.

[Roger]

Bill, I love you, man, but you are one wildly cynical dude. Let's separate out corporate finance principles from theories about motivation for a minute.

Certainly dirtbags abound, and we all can find plenty of these, but that is not what I am talking about. My post is about buybacks, their use and representation. Further, the impetus for the post was that poorly written NYT article that discussed the impact of buybacks on EPS that is just wrong. I can find shitheads in every corner of Wall Street and across Corporate America, but that is not what my post is about. Also, your point about EPS is true, but I wasn't arguing anything different. I was simply displaying how the NYT article's portrayal of the impact of buybacks on EPS was just factually incorrect.

Nothing I've written is in the least bit esoteric. It's pretty much straight down the middle of the fairway stuff. Your postulation about buyers and sellers is pure noise (of course the company is a liquidity provider, so what?) relative to the issues that really matter - best use of cash and signaling. Your commentary about ROIC is absolutely right. There is no question that buying stock, regardless of how it is financed, should be viewed as having bought the company today (very much akin to Buffett's perspective).

But what does this say about organic investment in the business and the opportunity for attactive returns there? This is the real issue.

If I can achieve higher returns investing in new projects than I can investing in my own stock, that is what I should do. This clearly has positive signaling effects for my company as a growth stock. However, if I am fundamentally overcapitalized because of a lack of attractive growth opportunities but my business is appropriately leveraged, I might raise the dividend or even pay a special dividend. Alternatively, if I am both over-capitalized and under-leveraged, why not borrow money cheap, take on a prudent level of debt, get a corporate tax deduction and give my shareholders the opportunity for a long-term capital gain? I just think the comment that buybacks are stupid all the time makes no sense and is neither reflective of the real world nor maximizing of firm value.

Bottom line: the appropriateness of buybacks vs. dividends depends upon the nature of the company - the volatility of its cash flows, its point along the company lifecycle (lots of organic investment opportunities or not) and its capital structure. Armed with those three data points one can make a rational assessment of dividends vs. buybacks. As always, thanks for the provocative comment.

[Bill a.k.a. NO DooDahs]

I've done case studies on quite a few buybacks - ignoring the buyback announcements that never result in actual buybacks or underdeliver the announcements. I have yet to see a buyback that was a more effective use of capital than returning it to shareholders. This will probably morph into another post on buybacks at my blog.

First, the important and philosophical point: buybacks benefit shareSELLERS. Holders of the stock don't benefit as much as the "unbelievers" who sell do. Return of the capital to shareHOLDERS is the more effective way to benefit those who continue to believe in the company.

Is the company an investment firm? If not, then why are they pouring capital into buying shares of anything? If so, then they must be lousy, if they have so much cash that they can't find anything other than their own shares.

Backward-looking, does the current share price exceed the average buy-back price by an amount higher than the company's own internal ROIC? If not, the buyback was a failure, wasn't it?

Multiple examples can be found where buyback schemes served merely to enrich insiders who were selling stock. Check out CTX for an example. And this wasn't mopping up options, this was selling of actual holdings! On top of that, the entire time the company was buying and the insiders were selling, the price was falling!

Y'all make interesting although esoteric points about the impact of buybacks on EPS, but let's look at it from an opportunity cost standpoint: the amount of cash it would take to influence either the EPS, or to actually make a difference in the bid/ask on a daily basis, would probably have more influence on the stock's price if it were converted to a dividend or special dividend.

For example, imagine that a stock that turns over the float once annually will buy back 5% of its float in a year; this is a hypothetical 5% increase in volume. You've charted some stocks; does that represent a meaningful increase? Unless it was done in a very targeted manner, i.e. very strict limit orders at a set price with unlimited volume bought on those occasions, that amount of cash can't influence the stock's price if it is spread over a year. If that amount of cash is deployed over a very short time period, it could double the average volume over a two-week period and drive the price up ... temporarily. And that would probably result in the following price being lower than the acquisition price the company paid.

Now that same amount of cash could raise the dividend yield of the stock by a full point for more than five years! That would have a powerful signaling effect on the market.

Having seen a boardroom or two in action, I suspect buybacks are done for political expedience more than anything else.

[Kris Tuttle]

Great example of the depth and richness of expertise you can get today in the online world versus traditional mainstream media outlets like the WSJ and not to even mention the CNBC hot air machine.

[Yaser Anwar]

Rob-

I agree with you. We should see more one time special dividends like WYNN's today, MSFT's & Phelps Dodges' a couple of months back.

The worst kind of buyback is- companies borrowing to finance buybacks. While such moves might have tax or other advantages, they simply replace equity with debt, which means shareholders get the buyback's benefits only at the expense of owning a more-leveraged company and the risk that an economic downturn could make it harder to service debt.

[robpas]

I love buybacks for what they tell me -- bottom line the firm has no other profitable growth opportunities to sink it's teeth into. If they did they would be investing in the business. Screw the buyback and return me the capital.

[Roger]

Bill, it's a little hard to respond to a statement and not a logical argument. In a vacuum, I have to disagree. Dividend changes are effective for permanent changes in policy, in my opinion, while buybacks are good to manage stock option dilution and to make significant changes in capital structure when they benefit the holders of capital. I'm not sure why you have such a bias, but you are a smart guy and I am sure you have your reasons. I'd be interested to know them.

[Roger]

Yaser, your statement about holding excess cash raising the cost of capital is not necessarily true. Some firms hold "excess" cash because of the volatile nature of their operating cash flows. This cash serves to reduce the risk of financial distress and, in fact, lowers the cost of capital by more than its poor stand-alone earnings power relative to the return from operating assets. So the real question is what constitutes "excess." Just holding a large amount of cash on your balance sheet doesn't necessarily mean you have excess cash from a value maximization perspective. So again, it is not that simple to make such a sweeping declaration.

Concerning the tax benefits accruing to a buyback, the key point is whether or not the buyback serves to reduce the cost of capital. As you likely know, a buyback will generally increase the cost of equity, though due to its lower proportion in the capital structure may in fact reduce the cost of capital. This is good from the perspective of maximizing the value of the firm. However, there is one key benefit of buybacks/seeking to optimize capital structure beyond simply the tax shelter/minimizing cost of capital effects: management focus.

This is why private equity firms are frequently successful - management is laser focused on the task at hand because the margin for error is low. Provided they have enough financial flexibility to do their jobs well, the added leverage and reduced capital base can have favorable effects of equity valuation.

[Bill a.k.a. NO DooDahs!]

I continue to be very negative on buybacks. If the cash can't be deployed through operations, it should be returned to shareholders through dividend increases or special dividends.

[Yaser Anwar]

"Using cash and synthetic share buybacks to manage stock option exposure is prudent corporate finance policy."

I'd like to highlight a company that's going to be doing this. In fiscal 2007, Cisco will spend $4 billion on share repurchases to offset potential dilution associated with stock options. (CSCO’s estimated 07 adjusted FcF is $3.8 billion, with a FcF of only 2%, substantially below the S&P 500 and other leading technology companies.)

Growth doesn't necessarily have to come from share buybacks. An example: Dell's announcement earlier this year that it would increase its buyback program by an additional $10 billion didn't slow the decline of its share price, which had begun to slide because of worries about operating results.

RE- What about the tax benefits from buybacks? Holding excess cash raises the cost of capital. Since interest income is taxable, a company that maintains large cash reserves puts investors at a disadvantage. How? because having too much cash on hand penalizes a company by increasing its cost of financing.

In theory, the share price increase from a buyback results purely from the tax benefits of a company's new capital structure rather than from any underlying operational improvement. Is that true in practice?