Markets & Finance

Selling Out for Buybacks


Earlier this year, management of media giant Tribune (TRB) took some dramatic steps to appease shareholders upset over the company's stagnant stock price. Tribune agreed to borrow as much as $2 billion to repurchase 25% of its shares, in a move designed to boost its return (see BusinessWeek.com, 6/20/06, "The Trouble at Tribune").

The announcement has done little to enhance the company's value, though. Tribune closed on Sept. 7 at $31.14, down eight cents for the day and well below the 52-week high of $39.06. "The buyback is expected to be funded by bank loans and publicly traded bonds," Standard & Poor's said in a report. The report noted that Tribune faces a weak revenue environment at both its newspapers and TV stations. S&P cut the rating on Tribune from A/Stable-A-2 to BBB/Negative/A-3.

SHAREHOLDER ACTIVISTS. It's just one example of how shareholder activists are forcing publicly owned companies to take on more debt to fund the buyback of their shares. "Whether responding to the pressure of private equity groups, dissident shareholder slates of directors, or unhappy money managers with large stakes in the company…(debt-funded) stock buybacks are yet another category of shareholder enhancement that can hurt credit quality because of the additional leverage," S&P warned last month in a report.

The pace of stock buybacks is set to shatter last year's record. Stock buybacks are on track to hit the $400 billion mark this year, according to a report by Morgan Stanley (MS) said it would spend $40 billion to repurchase its shares, after years of struggling to effectively invest the billions its software businesses generate (see BusinessWeek.com, 7/21/06, "Microsoft's New, Improved Spending "). "When companies can't find worthwhile capital investments of acquisitions, returning money to shareholders in the form of a dividend or a buyback can be a good option," says Fred Lane, chief executive of investment bank Lane Berry. Interest rates are still low by historic standards. It might even make sense for companies to fund buybacks with debt, assuming they don't take on too much leverage, according to Lane.

LEVERAGED BUYBACKS. Buybacks can be trouble, though. Even companies that can fund them with cash reserves or manageable amounts of debt often find that buybacks don't achieve their intended purpose of boosting a company's stock price. Shares of Time Warner (TWX) have declined this year since it announced a $20 billion stock buyback.

For companies with poor profit growth, taking on a lot of debt to fund a buyback that appeases investors can be a mistake. It can limit the financial flexibility needed for strategic acquisitions or investments. In extreme cases, it can raise the risk of default or even bankruptcy. Analysts say such buybacks are on the rise. "The increasing influence of private equity groups, hedge funds, mutual funds and other big investors makes it appear more and more likely that shareholder-friendly deals will be done whether the impact on credit quality is positive or not," S&P warned in its report.

Hedge funds are particularly eager to push for stock buybacks. These lightly regulated and often wildly profitable investment vehicles are awash with cash and can easily amass a large stake in a company, exerting enormous influence on management. McDonald's (MCD) was pressured by hedge fund investor Pershing Square Capital to borrow money so it could repurchase shares (see BusinessWeek.com, 2/20/06, "Attack of the Hungry Hedge Funds").

CAUSE AND EFFECT? Last month, Brinker International (EAT), which operates the Chili's restaurant chain, took out a $400 million line of credit just as it announced a $450 million stock repurchase. "That sort of deal was unusual until just two or three years ago," says David Ying, co-head of the restructuring department at investment bank Evercore Partners (EVR).

One credit expert warned that it's always difficult to establish a chain of cause and effect between debt and buybacks. Most corporations are so complex that they can argue the debt was used for an array of other purposes, should they so choose. But "obviously, any company that is buying back more stock…more quickly than it generates free cash flow is to an extent doing a leveraged buyback," says Carol Levenson, director of research at credit analyst Gimme Credit.

But regardless of the cause and effect, there's no question many companies that announce large buybacks also take on lots of debt. In many cases, earnings growth is difficult, which means companies can't afford to pay for the buybacks out of their pockets.

For example:

Mirant

After it was targeted by hedge fund Pirate Capital, Mirant (MIR) said it would buy back up to $1.25 billion in shares. Shares of the energy company rose after the announcement in July, benefiting shareholders such as Pirate, which had a 1.6% stake. But the company has been posting net losses and already has more than $4 billion in debt.

CBRL Group

CBRL (CBRL), which operates Cracker Barrel and other restaurants, announced an $85 million buyback last year. It was the latest in a series of such deals that have left the company with about $200 million in debt. Now the company is in a tough environment and earnings have declined 10 percent over the trailing 12 months.

TransOcean

Earlier this year, TransOcean (RIG) said it would increase its buyback program from $2 billion to $4 billion. But the Houston-based offshore drilling company's profits are declining on a year-over-year basis. Last month, it announced plans to offer up to $1 billion in debt, prompting credit rating service Moody's Investor's Service (MCO) to lower the credit outlook for the company from stable to negative.

Time Warner

Billionaire investor Carl Icahn made headlines last winter by trying to force a breakup of media giant Time Warner, on the theory that the sum of the parts would prove more valuable than the whole (see BusinessWeek.com, 8/14/06, "Carl Icahn Increases Time Warner Stake"). Icahn came to terms with the company, which agreed to boost its buyback program from $5 billion to $20 billion. That could be a huge burden on a company that already has $23 billion in total debt.

RISKY BUSINESS. Shareholder activists often serve a good purpose by shaking up poorly performing management or rooting out conflicts of interest. There's certainly nothing wrong with compelling a company to boost the financial return for its owners. But in cases where companies with poor earnings growth are taking on massive amounts of debt to fund repurchases, the risks of trouble down the road are high.

One thing is clear, however: Should such companies run into trouble and declare bankruptcy, investors on Wall Street will figure out a way to profit from that, too.


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