Share Buybacks - Pros and Cons - 29-Oct, 2008

Share Buybacks - Pros and Cons

http://blog.qovax.com/2008/10/29/share-buybacks-pros-and-cons/

This past week I read an article on GuruFocus by Andrew Mickey, CIO of Q1 Publishing, entitled “Don’t Buy In To Share Buybacks”
and the ensuing discussion piqued my interest. In his article, Andrew
presented his arguments about why share buybacks are bad news in the
long run for shareholders.

I agree with his perspective somewhat. I don’t think it is possible
to make an indiscriminate statement whether share buybacks are good or
bad without examining the underlying motives behind each buyback
decision.

As I’ve mentioned in my article Value Investing - Evaluating Management,
it is important to always ask if management is acting on the best
interests of the shareholders. Similarly, when evaluating whether a
share repurchase is a good decision, we as investors need to decide if
management made the right decision under the circumstances.

The Cons

As Andrew has pointed out, share buybacks may not be all good news.
There are three motives we need to watch for when evaluating
management’s decision of buying back shares with our money:

Mask Over-dilutive Stock Option Grants

One of the biggest crime management could legally commit is to grant
themselves massive stock options at the cost of shareholders. Buffett
has always said that if management wants a piece of the action they
should pay. Nonetheless, stock options, when awarded reasonably based
on certain performance metrics, can be an effective form of
compensation to align management interests with shareholders.

Back
in 1999, Microsoft issued about $60 billion worth of stock options to
its employees.[1] At the time, Microsoft earned a net income of $7.8bln
but issued options worth $9bln.[2] And none of these options were
expensed, but that’s a story for another time. It wasn’t until 2003
when Microsoft announced it would stop issuing stock options, start
granting restricted stock and start expensing stock awards.[3] One
wonders if the $70bln stock buyback beginning in 2004 is merely to
reduce the dilutive impact from the stock options it has issued
throughout the years.

Earn Performance Bonuses

Carefully chosen metrics for performance-based compensation is
essential to the success of a business. Management incented to increase
share price could resort to gaming the numbers to prop up the stock
price and ultimately earn their bonuses.

Buying back shares could achieve the same effect. By reducing the
number of shares outstanding, management can almost immediately
increase earnings per share, increase return on assets and reduce PE
all at the same time. Best of all, management would have earned their
bonuses at the cost of shareholders money!

Lack Capital Allocation Skills

Sometimes, buying back shares could mean management lacks the skills
to find better use of excess capital. The question to ask here is can
the business earn a better return investing elsewhere? A dollar
retained should increase the value by at least a dollar. If not, the
cash should be returned to the shareholders so they can divert the
funds into other investments.

This is where understanding the business is important. Could the
business earn a better return by acquiring a related business on sale?
Should management invest in organic growth to sustain future revenues?
Every case is different and need to be examined carefully.

The Cons

Needless to say, not all share buybacks are bad. Share buybacks can be beneficial in the following ways:

Catalyst to Narrow The Gap Between Price and Value

Substantial share buyback programs typically have an effect of
helping the price converge on the intrinsic value sooner. This is, in
fact, one of the weapons in the arsenal of activist investors to help
realize the value of their investments.

When a share buyback is announced, management is usually sending a
signal that the stock is undervalued and management is confident in the
growth in future cash flows. Coupled with significant insider open
market purchases, a share buyback could boost the share price in a
meaningful manner. On the other hand, if after announcing the share
buyback, management is quietly selling off their shares, you have to
question the real motive behind the repurchase.

Tax Efficient Way to Return Money to Shareholders

Back in the days when capital gains tax is lower than dividend
income tax, a share buyback is a more tax efficient way to return money
to shareholders than paying a dividend. But since both capital gain and
dividend income are taxed at the same rate now, the tax advantage has
disappeared.

However, at the corporate level, there are still tax benefits to be
had when buying back shares. A company that spends $100 million in cash
to repurchase its shares will relieve itself of paying $9 million in
taxes on the interest income it would have earned on the same amount
had it kept the cash in a money market account earning 3% (assuming no
growth in interest).[4] This tax saving in theory should translate into
a $9 million increase in market price in a share buyback. In short, by
returning the excess cash to shareholders, the business continues to
generate the same cash flow but on less equity divided into lesser
number of shares. Not a bad way to return money to shareholders and
save on taxes.

Lower Cost of Capital

Buying back shares can be enhanced by utilizing cash from issuing
debt. Remember, excess cash held at company is not free for company to
use. After all, the cash belongs to the shareholders and the
shareholders expect a decent return on the equity.

By issuing debt at an interest rate lower than cost of equity to buy
back shares, the company has just increased leverage and lowered the
cost of capital. This magnifies the return on invested capital to
shareholders. What’s more, the interest expenses paid on the debt can
be tax deducted. Again, the tax saving translates to an increase in
share price.

Prevent Deworsification

When there are no other investments that could yield a better return
than buying back shares, management should just return the money to
shareholders. Spending the money on share repurchase also has the
effect of preventing management from getting into silly acquisitions
that would in the end cost huge losses to shareholders. Peter Lynch
calls these deals deworsifications.

Dumb acquisitions could cost losses that run well into the future.
Buffett calls buying Dexter Shoes with $433 million worth of Berkshire
stock in 1993 the biggest mistake he has made. Although Dexter is no
longer making shoes, Berkshire shareholders has lost $3.5 billion on
the deal thus far and will continue to lose money as the shares
increase in value.[5]

Conclusion

In summary, don’t be too quick to credit or discredit a buyback
without first identifying the motive behind the decision. After all, if
you were to draw a line here and consider all buybacks to be bad, you
could be missing out on many, many great companies selling at a
discount.

References

1. Rob Landley, Why Microsoft’s Stock Options Scare Me, The Motley Fool, February 17, 2000.


2. Bill Parish, Microsoft Financial Pyramid, Parish & Company, November 17, 1999.


3. Todd Bishop, Microsoft to End Stock Options For Employees, Seattle Post-Intelligencer, July 8, 2003.


4. Richard Dobbs & Werner Rehm, The Value of Share Buybacks, The McKinsey Quarterly - McKinsey & Co., September 20, 2005.


5. Jonathan Stempel, Buffett Calls Dexter Shoe His Worst Deal Ever, Thomson Reuters, February 29, 2008.


6. Justin Pettit, “Is a Share Buyback Right for Your Company?” Harvard Business Review, April 2001.