Traditionally, shareholders have welcomed stock buybacks. That's because such moves put money into investors' hands in a tax-efficient manner and usually presage a healthy bounce in the stock price as well. But the appeal of the high-stakes version of buybacks now being served up by Wall Street and Corporate America is much less certain.
Rather than going into the open market to buy shares gradually over several months as trading volume and free cash flow permit, more than a dozen companies this year have launched tender offers to buy roughly 10% to 20% of their stock directly from shareholders in a matter of weeks. What's more, some companies are borrowing heavily to finance all or a substantial part of their purchases, a tactic that can damage their credit standings.
On Nov. 12, for example, HCA Inc. (HCA) completed what Thomson Financial (TOC) says is the biggest-ever tender for a stock buyback. It offered $2.5 billion for 13% of its outstanding stock -- in just 30 days, borrowing all of the money. The stock rose 3.3% during the tender, but its bonds were downgraded to junk by Standard & Poor's (MHP) and Fitch Ratings. Moody's Investors Service rated them junk already. Limited Brands Inc. (LTD) is scheduled to close the second-biggest deal, a $2 billion stock tender, on Nov. 22, borrowing half the sum.
The appearance of big tender offers is part of a broad resurgence of stock buybacks. In the third quarter of 2004, some 175 companies announced plans to buy back stock worth $77 billion, the highest dollar amount in four years, says Thomson. Although Microsoft Corp.'s (MSFT) $30 billion buyback pumped up that number, the trend continues strong. In the first six weeks of the current quarter, an additional 70 companies announced $54 billion worth of deals. And more will follow. Says Stefan Selig, an investment banker and vice-chairman of Banc of America Securities (BAC): "Repurchasing stock is one of the most frequently discussed corporate finance topics in boardrooms today."
What's driving the trend is a combination of low interest rates, languishing stock prices, and optimism that profits and cash flows are improving. Together, they give companies the chance to increase earnings per share by buying back stock, even if they lose interest income on the cash they use to make the purchases or have to pay interest on borrowed money.
For investors, the deals bring mixed blessings. The buying supports stock prices but makes earnings per share less reliable as an indicator of corporate performance. Because they reduce the number of shares outstanding, buybacks mathematically increase earnings per share and make companies seem more profitable even when their income is unchanged. Bond investors tend to lose out all around. Buybacks increase corporate leverage, making existing debt more risky. Michael W. Roberge, chief fixed-income officer at MFS Investment Management mutual-fund group, says assessing the risks of buybacks by companies whose bonds MFS holds is "our No. 1 focus" for 2005.
Roberge learned the hard way. His firm owned HCA bonds on Oct. 13 when the company announced its tender simultaneously with a confession that its third-quarter earnings would fall short of Wall Street's expectations. The news underlined fundamental problems in HCA's business -- such as slowing growth in revenue per patient and collections from the uninsured -- that would seem to call for financial cau- tion instead of added leverage. Roberge, who has sold some of the firm's HCA bonds, says: "It looks like a pure ploy to keep the stock price up."
HCA Senior Vice-President Victor Campbell rejects the charge. He says that long before quarterly results weakened, the company had been mulling a leveraged buyback as a "prudent" use of its financial resources because interest rates were low and the company had more cash flow than it needed to keep up its business and grow in its existing markets. A tender, Campbell says, enabled the company to lock in quickly the earnings lift available from today's low interest rates and stock prices. HCA says its borrowing will cost an average of 4.6% on the extra $2.5 billion of debt. After allowing for that expense, it figures that reducing its share count will boost earnings by about 15 cents a share, to between $2.75 and $2.90 next year.
Similar math looks enticing to other companies as well. Limited Brands is borrowing $500 million at 5.25% for 10 years to go with other borrowing and cash to pay for its $2 billion tender, a deal it announced on Oct. 6, along with a $500 million special dividend and an earnings warning. Although Limited has told investors that financing the deal will cut net income by $40 million, or 6%, the buyback would increase earnings per share by 9%, if the tender is completed at $29. Limited did another tender for $1 billion in April. But the debt to finance the latest deal comes at the cost of lower credit ratings. Moody's, which cut Limited's debt to near junk, noted that in the past the company has financed buybacks with proceeds from asset sales. Limited officials did not return calls and their investment bankers declined to discuss the deal.
Even without using debt, making buybacks through tender offers has advantages. That's especially true for small companies, many of which see their stocks starved for attention now that Wall Street investment banks have cut back on analyst research, says Jon Einsid- ler, senior managing director of Georgeson Shareholder Communications Inc., a proxy solicitation firm. For instance, cpi Corp. (CPY), a New York Stock Exchange-listed company without regular analyst coverage, tendered on Nov. 12 for 13% of its stock. The company, which operates photo studios in Sears, Roebuck & Co. (S) stores, is offering up to $14 a share for stock that was trading at $12 before the deal was announced. "A whole lot of companies with market capitalizations of $100 million to $200 million are looking at this," says Einsidler.
Indeed, for companies whose stocks are thinly traded, tenders may be the only way to buy back substantial numbers of shares without running up their price. Shares of Blyth Inc., an NYSE-listed seller of candles and home decorations, traded an average of only 270,000 shares daily before the company bought back 4.9 million shares, 11% of its outstanding stock, in a tender on July 16. "If you want to buy back a lot of your stock, tender offers can be much more efficient than open market repurchase programs," says BofA's Selig.
That may be true for the companies. But whether such extreme buybacks -- particularly those paid for with debt -- are as beneficial to investors is another question. Regular repurchase programs allow companies to cut back their buying if their cash flow falters, notes Carol Levenson, director of research at Gimme Credit, an independent firm of bond analysts. That's important for investors to remember. After all, executives can be tempted to take a chance on an aggressive buyback at precisely the wrong time -- when their stock price is down because their business is weakening.
By David Henry in New York