Share buybacks - some extension material

Deutsche Bank On Share Buybacks: Truths, Myths And Technical Bits

By Rupert Hargreaves on October 29, 2015 in Business

“No one really wants to talk about it, but there is a humongous contradiction at the heart of the ongoing share buyback mania.” — Deutsche Bank on buybacks. 

The latest issue of Deutsche Bank’s Konzept magazine takes a look at share buybacks and the effect that they’re having on the financial system, questioning if companies really should be spending their hard earned cash buying back stock. 

Over 400 companies in the S&P 500 repurchased stock last year, spending a total of $575bn in the process. That is about 3% of the index’s market cap and is up 14% from 2013, nearly matching the $600bn record set in 2007. What is more, the Buyback Index (a subset of 100 companies with the highest buyback ratio) has outperformed the S&P 500 by almost a third since 2010, as well as over most periods since 2000.

But despite the market’s love of buybacks, you don’t have to look far to find a criticism of this method of cash return to investors. Common criticisms are; buybacks do not add shareholder value or they destroy it; companies are hurting themselves and the economy by not using the cash to invest; companies buy high rather than low and are hence terrible investors; buybacks enable executives to manipulate earnings and compensation. 

On the other hand, supporters of buybacks argue that they’re a more flexible and tax-efficient way for companies to return excess cash to investors and offset dilution from stock or option grants.

Value of buybacks and dividends by year

Buybacks: Common misconceptions

Some common misconceptions surround the buyback argument. For example, Konzept points out that it is ridiculous to suggest that buybacks make a firm more valuable. Similarly, it is entirely wrong to argue they have led to less investment. 

So what’s the truth behind the argument? Well, there are many different factors that all influence the effect of buybacks. Tax advantages really do provide an incentive for companies to buy back stock. Dividends are taxable to investors who receive them whereas share buybacks are taxable as capital gains only to investors who sell their shares. Furthermore, if debt is used to finance share buybacks, the interest expense is tax-deductible, which may reduce the firm’s weighted average cost of capital. 

In general, investors often cheer when buybacks are announced, Konzept suggests that they do this because investors are generally suspicious of what companies will do with excess cash. Buying back stock and effectively returning cash to investors removes the risk that the company may waste it on unsuitable acquisitions. 

“This could alter valuations more than theory or tax policy would predict by reassuring investors that management is acting in their interests (alleviating what text-books call the agency problem).

This is no theoretical concern. In 2011, for example, Hewlett Packard’s operating cash flows were $13bn with dividend pay outs of $840m and share buybacks worth $10bn. It also bought Autonomy for $11bn in stock but post-due diligence most of the purchase price was written off. Subsequent buybacks dropped to $1.5-2bn. It was not that HP had not paid out a lot of cash – it just did so to Autonomy’s shareholders rather than its own.

RadioShack and Blackberry provide another perspective. RadioShack came under severe criticism as it headed for bankruptcy having spent some $1.5bn on buybacks between 2005 and 2011 – worth roughly three-quarters of its total assets in 2005. The maker of the iconic Blackberry device, was similarly criticised for spending $3bn between 2010 and 2012 – roughly 30 per cent of its assets. Perhaps both could have soldiered on a bit longer had they instead paid wages or invested the money.” — Deutsche Bank on buybacks. 

Nevertheless, in general, companies are struggling to find a use for all the extra cash they’re generating. According to Deutsche Bank’s figures, America has worked relentlessly to cut costs and improve margins across most sectors. Last year the S&P 500’s operating cash flow margin hit 15%, one of its highest levels ever. Companies have further increased free cash flow by refinancing debt at significantly lower interest rates.

Capital spending still rising

America isn’t scrimping on capex to pay for additional buybacks. US non-residential investment (a proxy for corporate capex) is running at 12.8% of output in nominal terms, or 13.3% in real terms, matching the 2007 peak and well above the highest levels of the 1980s and 1990s after adjusting for inflation. But that’s not all, companies have shifted their capex spending from investing in structures to investing in high-tech equipment, software and various kinds of intellectual property all of which have seen prices fall over the past 15 years. However, prices for structures are some three times higher than the personal consumption price index since 2000.

All in all, after adjusting for inflation and the type of capital equipment being purchased, companies are spending more than ever before on capex, despite record buyback levels. Home Depot is a great example of this change:

“Home Depot is a good example of a company that drastically shifted its capex strategy in response to market changes. Before the crisis, the company spent about 55-60 per cent of its operating cash flow on capex as new superstores were built. But with the growth of internet-related retail activity, Home Depot no longer needs more physical stores. The resulting shift in focus to its online capabilities has cut capex to about a fifth of operating cash flow. The company has used the freed-up cash to resume a large share buyback program. What if it had kept the cash instead? Would critics of buybacks be happy knowing the money might get ploughed into more and potentially redundant super stores? Or would they prefer management diversify within the big-box retail sector, perhaps by buying Sears; or how about turning that excess retail space into cloud computer server farms?” — Deutsche Bank on buybacks. 

This brings the buyback argument onto the issue of debt. Of the 329 non-financial companies that repurchased stock during the past twelve months, net cash flow only covered 93% of the buybacks. 7% of the total buyback spend was funded with debt, about $40bn in dollar terms. About one-half of repurchasing companies had insufficient net cash flow to cover their share repurchases, for this set of firms 60% or $175bn worth of buybacks were financed with debt.

Other factors to consider

With so many companies using debt to bulk up repurchases, Deutsche concludes that the buyback binge is no longer about just using up excess cash. So what is the reason behind the leveraged buyback strategy so many companies now have in place? Apart from the obvious benefit of a lower cost of capital, Deutsche floats the thesis that many companies believe that their stock is trading below intrinsic value. Although, buybacks generally tend to be pre-cyclical, so it’s unlikely that this is the case. 

The most likely driver of the buyback boom is executive compensation. A number of studies have shown a strong link between buybacks and bonus arrangements. This also ties in with the above motivation that companies can use buybacks to hit earnings targets. 

“To conclude, there is no tractable way to sort out the extent to which share buybacks are used primarily for constructive purposes, such as returning excess cash, versus serving as a tool to enhance executive pay. This is not a one-size-fits-all issue – rather the answers vary by company. The problem, unfortunately, is that misinformation abounds and rather than participate constructively in the debate most companies have instead piled on the buybacks while they can. Boards would help their cause by eliminating any link between buyback activity and executive compensation. The debate over inequality will rage on, but at least companies can offset the negative perception of buybacks to ensure the tool remains in place.” — Deutsche Bank on buybacks.