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The Buyback Boomerang


After Stephen Wolf became chief executive of loss-plagued US Airways Group Inc. (U) in 1996, he ordered a massive share-buyback plan to pump up investor confidence and earnings per share. From 1998 to 1999, he spent $1.9 billion to buy stock. But it didn't do the trick: The shares fell by 70% from their $83 high in July, 1998. By the time the airline filed for bankruptcy in August, 2002, the shares traded at just $2. Now, the Arlington (Va.) company wants the government to back a near $1 billion bailout--half of what Wolf fruitlessly spent.

Wouldn't it be nice if US Airways had that spare $2 billion about now? The carrier isn't the only cash-strapped company that used up a small fortune buying its own stock. Much of Corporate America went bonkers for buybacks in the 1990s, with little to show for it now. During the bull market, cash-rich companies bought record chunks of their stock at peak prices, a BusinessWeek analysis of Thomson Financial data shows. The buyback boom absorbed the bulk of profits in many cases, leaving companies strapped in these tough times. "Share-repurchase activity was a sign of overconfidence," says Charles J. Plohn Jr., head of Merrill Lynch & Co.'s special equity transactions group, which specializes in buybacks. "Itcontributed to overpriced markets."

That's not what they were supposed to accomplish. Buybacks have long been billed as a good use of excess cash. When companies' shares are undervalued, it makes sense to buy them and boost the share price. That's exactly what many did in the two weeks following the October, 1987, market crash. Some 600 companies announced buyback plans worth roughly $44 billion--more than was spent in each of the two previous years. Today, with most executives getting the bulk of their compensation in the form of stock options, buybacks serve another crucial purpose: As options are exercised, buyback programs soak up the excess stock and offset the dilution of existing share values.

But in the go-go '90s, many buybacks made little sense. Companies spent huge sums--sometimes even borrowing to buy their shares. At the market's peak in 2000, they spent $216 billion to complete more than 5,800 buybacks. And those shares were often bought at the high. Worse, the buybacks couldn't stay ahead of the growing number of cashed-out options: After a decade of huge buybacks, the number of outstanding shares remains about the same.

How companies should spend excess cash is a classic finance question that has dogged academicians and executives for decades. Returning cash to investors--via either buybacks or dividends--can build shareholder loyalty. But it also uses up valuable reserves that could be used to pay down debt, upgrade equipment, or finance new products and acquisitions. Or the cash can be kept on reserve for a rainy day.

These choices are not necessarily better. Indeed, plenty of mergers have gone awry, and new products often fall flat. But when it comes to buybacks, managers routinely get the timing wrong. "One of the major ironies in the world is that people aren't very good at evaluating their own stock," says Steven Zamsky, a corporate bond strategist at Morgan Stanley. "After the buyback, they've taken cash out permanently. It's just gone."

Consider Hewlett-Packard Co. (HPQ) The computer-equipment giant spent $6.4 billion to buy back its shares from November, 1998, to July, 2000. At the time, HP said the shares were a bargain. But it overpaid: The shares now trade at about $14, or 73% less than the $53.60 they paid, on average, during HP's buyback binge. If HP had those reserves now, it might be in a better position to weather the tech downturn and its own profit slump. "One of the biggest problems is that managements tend to be flush with cash when profits are high," says veteran auto analyst Maryanne Keller. "And that is absolutely the wrong time to buy back shares."

Keller and others argue that cyclical businesses with high fixed costs, such as computer manufacturers and carmakers, should avoid buybacks. "They don't have the money to burn," she adds.

Some critics believe the buyback frenzy was nothing more than executives seeking to maximize their own wealth. "They boost the price in the short term and then sell their shares," says Kathleen M. Kahle, a University of Pittsburgh finance professor and author of the February, 2002, study When a Buyback Isn't a Buyback. Kahle found that the higher the percent of in-the-money options held by top brass, the more likely the company was to execute a buyback plan. The cycle of issuing options--and offsetting shares once options were exercised--pushed share prices ever higher and fed the stock market bubble. "If the marketplace keeps taking your stock higher and higher, then you're just chasing price to offset dilution," says Merrill's Plohn. "That doesn't make any sense."

Now, even with the market depressed and fewer executives cashing in options, investors can't breathe a sigh of relief. The average "burn rate"--jargon for the pace at which companies issue options--is now 2.7% of outstanding shares a year, more than double the 1.08% rate of 1991, according to executive-compensation firm Pearl Meyer & Partners. That means millions of options are still in the pipeline--enough to keep companies buying back their shares.

What's really galling is that many companies went into hock during the late 1990s to finance buybacks. In 1998, a record 60% of the corporate debt issued went to pay for stock buybacks, according to Morgan Stanley's Zamsky. "Companies figured the cost of capital was so low that they'd borrow," he says.

Mounting debt is why Eastman Kodak Co. (EK) decided to suspend the remainder of a $2 billion buyback plan last year. Despite spending $1.8 billion over almost two years, Kodak's stock plummeted 54% from its $79 high during the program. Meanwhile, profits cratered, and debt more than tripled, to $1.4 billion.

Even without borrowing, spending cash to repurchase shares can hurt credit ratings. "Buybacks are all well and good, but if there are no profits, that impairs the balance sheet and stymies future growth," says UBS Warburg's Justin Pettit, executive director of Strategic Advisory Group in New York.

Given how skeptical investors are these days, buybacks are unlikely to get the warm welcome they once did. In the '80s and '90s, the mere announcement of a buyback would give a stock a 3% to 4% pop without spending a cent. Now, such signaling is likely to backfire, says Merrill's Plohn. Companies that announce a buyback but never follow through on it risk creating a credibility problem with investors. "It looks like you were just trying to hype the price of the stock," says Plohn.

Investors must realize that they can't take buybacks at face value. Many repurchases have been little more than costly attempts to jack up share prices and enrich execs. Ultimately, the only reliable driver for share prices is profits.

Read a Letter to the Editor about this story. By Mara Der Hovanesian in New York


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