Friday, January 13, 2006

What Makes Buybacks Effective?

The January 23rd edition of Business week has an interesting article about “The Dirty Little Secret About Buybacks.”

Buybacks are often viewed as some sort of a panacea by investors. The return of capital to shareholders can take two forms, dividends or share buybacks. But there are problems with following share buyback announcements too closely or blindly.

First of all, a share buyback announcement is just that…there is little demonstration of management’s desire to actually execute anything. I know of one company that having announced its intent to buy back stock, proceeded in the next seven years to pick up less than 10,000 shares!

Secondly, buybacks might not be done at prices that create value for shareholders. For example, Hewlett Packard in the period between October 1998 and October 2000 spent over $10.5 billion in share repurchase activity at prices that ranged anywhere between the mid-$20’s to the low $60’s with much of it coming during 1999-2000 at prices between $40 and $60. The stock at a current $31 with a market cap of only about $90 million shows very little value creation benefit from this activity.

Third, buybacks frequently are a camouflage for share issuance. One of the best examples of this has been Merrill Lynch. The company has spent almost $14 billion on share repurchases since December of 2003, yet the fully diluted share count has only recently dropped below its December 2003 level. The share base was just about 975 million shares outstanding, despite all of the buyback activity has dropped to only 968.5 million. The buyback was merely sopping up the issuance of stock through generous stock options that were executed and generally sold. The treasury appeared to be merely providing a ready market for executive stock sales, at least in my opinion. Just think about spending $14 billion to effectively buy back 7 million shares…effectively over $2000 per share. Obviously, the company was buying back stock in the open market, but issuing stock “on the other side of the trading desk!”

The Business Week article highlights the fact that the S&P 500 companies spent about $315 billion in buybacks last year but the share counts rarely are reduced significantly. According to the article, only 108 companies in the S&P have reduced their share counts by 2% or more.

Share buybacks can also signal other messages…the company may be finding fewer profitable capital projects in which to invest. There is nothing wrong with that admission, but managements should return capital in this manner without paying too much for the remaining intrinsic value.

Too often, share buybacks have been used to inflate a stock price above a certain threshold to award managements with bonuses. We should examine all management compensation packages carefully to ensure that such reward systems are not in place.

Buy backs will only create value if the stock is purchased at prices below intrinsic value. If a company is buying back stock at prices above intrinsic value, we remaining shareholders are “stuck” with misappropriated capital allocation decision.


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