Information Arbitrage to the NYT on Share Buybacks: Analytical Rigor Required
After picking up today’s New York Times Business Section, a story immediately caught my eye: Why Buybacks Aren’t Always Good News, by Gretchen Morgenson. Now this is a topic of more than passing interest to me, having been both an M&A banker and an equity derivatives specialist much of my career. But after reading the story I have to admit I was left a bit flat, and found myself asking the following question: was this intended to be an editorial with a discrete agenda or a story with the fact presented without bias? Because I have to tell you, this is a very complex, textured issue, of which little complexity or texture was introduced into the piece. So, for purposes of catharsis, I will note down a few of the more salient points here.
1. Buybacks don’t always increase EPS
Huh? Don’t they increase EPS, by definition, because there are fewer shares in the denominator of the EPS calculation? Isn’t this the whole point? Answer: NO. There are two ways to look at a share buyback - from a corporate finance perspective and a GAAP earnings perspective. From a corporate finance perspective, the cost of a share buyback (purchasing an asset with the riskiness of your own stock) should properly be reflected as your cost of equity. But forget about this for a moment - we are focusing on EPS. From a GAAP perspective (the one that matters for EPS purposes), the impact of a share buyback is one of two things, either: (1) the opportunity cost of excess cash you are using to buy the shares (therefore your after-tax return on cash); or (2) the cost of debt used to finance the purchase (therefore your after-tax cost of debt). So, depending on your after-tax return on cash/cost of debt relative to your net margin, share buybacks may be either anti-dilutive or dilutive. I am so sick of the throw-away line “Share buybacks inflate EPS” - because it just isn’t true. Whenever I read this in an article the credibility of the piece drops precipitously. This from the story:
Many investors applaud the buyback binge, considering these programs entirely beneficial. After all, buybacks support a company’s stock price and buoy per-share earnings by reducing the amount of stock outstanding.
Sorry, wrong.
2. Using cash and synthetic share buybacks to manage stock option exposure is prudent corporate finance policy
And the story goes on to say:
But less obvious to investors are the downsides associated with buybacks. By artificially inflating a company’s earnings per share, repurchases can mask business slowdowns, for example. Companies can hurt their financial positions by putting scarce cash into repurchases. And when buybacks are used to offset multitudinous stock option grants to corporate executives, an even more pernicious outcome can occur: the purchases may actually destroy shareholder value by forcing companies to essentially buy stock in the open market at high prices to cover shares sold at lower prices to executives.
Ok, so we’ve already seen one egregious factual error by stating as a truism that share buybacks “artifically inflate” EPS. And then we see that “repurchases can mask business slowdowns” - I guess if one doesn’t read financial statements, read the MD&A in the 10-K and 10-Q and lives in a cave this might be true. And yes, if a company who is ill-equipped to fund repurchases undertakes them it could potentially increase the likelihood of financial distress. But the coup de grace is the stock option example. Let’s discuss the nature of option plans, for a moment.
Regardless of what tech CEOs might want you to believe (and have vigorously argued in front of and lobbied the Financial Accounting Standards Board and Congress), stock options cost real money and have a real value. But the positioning of this story is both ludicrous and false. Companies grant options as a form of compensation. They cost money. The cost is eventually crystallized when options are exercised and stock is sold at below-market prices. The difference between the cost of the stock at exercise and the strike price, after-tax, is the cost of the option to the firm. Now this cost could have been paid in cash or paid in stock. The nature of the currency really doesn’t matter, as the author of this story would have you believe. Options aren’t just a transfer of value from company to employee without getting something in return - the company gets the service of the employee. This creates value for all shareholders.
Companies generally have two distinct policies for addressing the future dilution (read: crystallizing the cost of the options) arising from stock option grants: (1) entering into derivative strategies to participate in the upside participation of the stock in the future without consuming cash today; or (2) using open market stock buyback programs to reduce the amount of outstanding shares, over time, to offset the impact of option exercises. Either one of these strategies are prudent ways of managing this cost which is real yet whose amount is not precisely known at the time of grant. But the article really serves as an indictment of stock option programs, in general, which is just ridiculous. Either that or the person doing the writing has no idea what they are talking about, which I’ll assume is not the case.
3. Rating agencies are sometimes out of touch with the real world
And the story goes on. Now an analyst from S&P chimes in, and doesn’t really serve to enhance the analytical rigor of the discussion.
Clearly, not all buybacks are created equal — at least for investors. And as the numbers of buybacks grow, the manner in which they may mask a company’s true performance becomes more problematic.
“We have a concern here that investors may not appreciate the full impact that the buyback has on the earnings per share,” said Howard Silverblatt, senior index analyst at S.& P. “When the buybacks stop, where is the growth going to come from?”
Adding to the anxiety about repurchases, Mr. Silverblatt said, is the fact that the shares have not been completely retired. The company can bring them back onto the market at any point; this would dilute existing shareholders’ stakes.
“What is the company going to be doing with these shares?” he asked. “It is an enormous amount of assets under control of management that has not been retired and could be put back into the market.” Using cash to pay dividends would be far preferable, of course, especially given the lower tax rates that apply to such payments. But managements are wary of dividends because, once they grant them, shareholders come to expect them.
Howard, are you kidding me? It is not rocket science to figure out the imapact of a share buyback on EPS. If you have a financial model it should take you about 30 seconds. So who are you worried about? Widows and orphans, sell-side analysts, institutional investors or hedge fund managers? Nobody here is fooled, Howard. So chill out. “When the buybacks stop, where is the growth going to come from?” From operations or M&A deals, Howard. Where else? And those buybacks may not have been the driver of EPS growth in the first place - you’ve got to run the numbers, pal.
And the point about the shares not being retired and “The company can bring them back onto the market at any point; this would dilute existing shareholders’ stakes.” This is called a secondary offering. Large companies seldom do them. Small companies frequently do, and there are things called filing requirements. Nobody is going to be blindsided. Whether or not the shares are in Treasury or newly issued is neither here nor there; the Board can authorize new shares to be issued if Treasury shares are not sufficient to cover the planned offering. So your whole point about this being an issue of information asymmetry is absoutely fallacious.
You are right about dividend policy - it is much less flexible than buyback policy for reasons of signaling. But that is a mighty small point in the sea of other stuff you said, in which you are I are in heated disagreement.
4. There are many legitimate reasons (and reasons for concern) for buybacks, precious few of which were mentioned in this article
Buyback programs look great from a distance. Up close, however, the picture blurs. More significantly, they may be a way for some corporate managers to think, once again, of themselves first and their owners second.
This is called an agenda. The data of the study that was frequently cited seemed neither compelling nor damning to me, and because a foundation of core understanding of buybacks was not established the article to me was a total loss. FYI, buybacks are frequently used to maximize the value of the firm, seeking an optimal balance between debt and equity given the riskiness of the firm’s business today and in the future. And yes, while there are certainly Boards and managements that are culpable when putting GAAP (as opposed to value) based compensation plans in place, this is getting harder and harder as SarBox and other regulations are tightenend to further clarify the fiduciary responsibilities associated with compensation schemes. Therefore, I can’t get too worked up about this stuff. What I do get worked up about is reporting that is not really reporting but editorializing. This should be carried in the editorial pages. This is called opinion, not news.
