Posted by: Howard Silverblatt on June 29, 2011
S&P 500 Q1,’11 stock buybacks increased 62.6% to $89.84B from the $55.26B in Q1,’10, but are up just 4.0% from Q4,’10 $86.36B. The 4.0% increase in buybacks from last quarter is significantly less than the 8.1% average price increase, and translates into fewer shares being repurchased. At this point, companies are continuing to use buybacks to control employee options as well as shares used for dividend reinvestment programs (DRP), with few companies venturing outside of the box to purchase additional shares, as was the common practice in late 2005 through mid-2007. So the question is, can the Buyback Bonanza return?
For the full report, use the link buybacks_20110629.rtf
The debate between buybacks and cash dividends dates back to even before I started at S&P, in 1977. In the time since, I’ve yet to see any convincing evidence — academic or practical — which proves that one is better for companies or shareholders than the other. The difficulty of obtaining proof lies in the inability to isolate the cause and effect over long enough time periods. To say that Exxon-Mobil is the largest company in the world today, because it has reduced its share count for 42 of the last 43 quarters (the only decline was in Q2, 2010 for the XTO merger, when the company was prohibited from doing so due to SEC regulations, but made up for it the following quarter), is as indefensible as saying that the Coca-Cola Company is successful because it has increased its cash dividends for each of the last 49 years (the company has paid cash dividends each year since 1893). The cause and effect are not clear; Exxon’s profits are what permit the company to buy back shares, just as Coca-Cola’s business model is what permits it to increase dividend payments. Then, there is Berkshire Hathaway and Apple, which employ neither buybacks nor dividends. Over the past year, 354 S&P 500 companies have spent US$ 333 billion on buybacks, while 386 issues have paid US$ 213 billion in the form of common stock dividends: 272 issues did both — with 161 of those issues spending more on buybacks than dividends, and 111 spending more on dividends. When a company repurchases its own shares, the transaction is called a “buyback.” Typically, buybacks are done in an open market operation, but, can also be done in a private environment from a large shareholder, or from corporate executives. In general, companies buy shares back in the open market, and the event is an immediate win-win for all. The buying adds upward pressure to the stock, and even if the stock is deteriorating, the decline should be lessened a bit by to the upward pressure. The buyback immediately reduces the share count, which, theoretically, increases each shareholder’s wealth in the company. More importantly it reduces the average share count used to determine earnings per share in that quarter, therefore increasing EPS, and showing a lower multiple. This EPS push is known as Share Count Reduction (SCR). Unlike a cash dividend — which, once paid, is gone forever — the shares purchased by the company sit in its treasury. From a company’s perspective, it owns the shares, and can reissue them at any point — subject to certain timing limitations. Reissuing the shares, however, would dilute earnings, so the more common use for the shares is for M&A, when dilution is more acceptable to the market.
The most common use for repurchased shares is to fulfill employee options, thereby, controlling earnings dilution. Options are used to compensate and incentivize employees. The decision to protect earnings from dilution via buybacks is a legitimate management tool. SCR is more controversial, and a more costly form of buybacks. When a company buys a share in the market, say at $50, and then exchanges it for an employee option, with a strike price of $35, it costs the company a net $15. If the company wanted to reduce its share count by one share, it would have to pay the full cost of $50. For this reason, SCR is not a common practice, as companies typically don’t hold shares in their treasury indefinitely. That said, the buyback bonanza, which started when buybacks went to US$ 66 billion in the fourth quarter of 2004, from US$ 46 billion in the third quarter of that year, then reached their peak of US$ 172 billion, in the second quarter of 2007, and declined to US$ 24 billion in the second quarter of 2009 was an unusual event. The period (Q4 2004 through Q3 2007) was marked by a strong bull market, as well as the actions of investors who bid up stocks from issues that did buybacks. The “reward” pushed companies to buy more stock — which was now more expensive — creating SCR which increased EPS, which in turn added to the upward pressure on stocks. As with all such circles, all was well, as long as all went well. The liquidity and housing bust quickly deflated the buyback bonanza. From there, companies have reentered the buyback arena, with few doing SCR, but most protecting their EPS with sufficient buybacks to prevent dilutions. Currently, through Q1 2011, share counts have been stable to slightly up, with a slight decline if the financial sector is subtracted. While buyback authorizations have increased in size and duration, the actual shares repurchased have been congruent to the issuance, with the major determinant of buybacks being the market price. The higher the price, the more options are in the money, and the more companies will need to spend to protect their EPS. Conversely, a Bear market would remove the value of many options, and reduce the cost of repurchasing what shares the companies do need.
The potential for another buyback bonanza is not unlikely. Companies have an abundance of available cash — Q1 2011 was the tenth consecutive quarter of record cash for the S&P 500 Old Industrials — for such operations, with cash-flow at record levels and earnings expected to post an all-time high in the third quarter. What is lacking for increased buybacks —and what I believe is holding companies back, at this point — is investor reaction. If investors start to bid up stocks which are increasing buybacks, I believe companies will respond with higher levels of actual buybacks, creating SCR, thereby starting the upward cycle again. At this point, there are few signs that investors are reacting in that manner. Last month, two issues drew attention to themselves for their buybacks. Integrated poultry business issue, Tyson Foods (TSN), gained 4.6% as it authorized a large buyback program, after it declined 6.6% two days prior on a poor earnings report; and semiconductor equipment maker, Novellus Systems (NVLS), gained 6.6%, after announcing a debt offering, with the majority of the money being used for buybacks. These are the type of investor reactions (to buybacks) which could push corporations to increase buybacks to the share count reduction level, from the current option-covering buying level.
The underlying question, however, as to whether increased buybacks that create SCR are useful and profitable, remains open. Part of the answer comes from what companies do with the shares. If they reissue the shares through an offering, then the result is measurable - purchased at X, sold at Y. If they use the shares for M&A — individuals typically prefer shares in a deal, since they tend to be tax deferred — then the question is: how good is the company management at combining the two companies (products, clients, personal)? In this case, the actual cost of the shares is secondary to the eventual “gains” of the merger. The third choice is for the company to hold the shares — while they could cancel them, few have chosen historically to do so — in which case there is no measurable result, since what the company might have done with the cash is never known.
At this point, even as large-cap issues boast strong balance sheets, with good prospects for future earnings growth, they remain nervous about their future, and shy of commitment. If, however, investors start to bid up buyback companies, it would be my belief that companies would respond and short-term stock prices, rightfully or not, would increase.