Wednesday, October 26, 2005

Sometimes Less Is More


Companies love to talk about “enhancing shareholder value.”


They usually do so when announcing share buybacks that frequently have very little to do with “enhancing shareholder value” and more to do with preventing earnings dilution caused by the generous option grants which the insiders who control the corporate money spigot give themselves, in the interests of “aligning management with shareholders.”

For all the self-congratulatory claptrap, when companies buy back stock it offsets the added shares from all those options grants and helps inflate the “Earnings per Share” calculation so as not to rouse the shareholders’ ire.

According to DuPont’s management, which announced a large share repurchase yesterday morning, the difference between their repurchase and others is that only about half of all announced share repurchases actually get done. (DuPont did not wait around to buy back stock in the open market: instead, the company bought $3 billion worth of stock from a Wall Street firm, which presumably shorted the stock to DuPont.)

One company that probably wishes it had not followed through on its buyback announcements must be Lexmark, the beleaguered printer company which earlier this month announced the biggest earnings miss I can remember at a mainstream technology-related company.

A 50% miss.

Management blamed all sorts of things—but it mainly came down to business falling off a cliff.

I don’t know about you, but in the old days—five to ten years ago—printers were an important part of my computer purchases. They churned out envelopes, labels, letters, and stacks of faxes that came in every morning filled with the research musings of Wall Street’s Finest, all the while consuming gallons of the expensive ink that made Lexmark’s razor/razor blade model so profitable.

But then all that information began to move around in digital form, and the printers piled up around my office like Tequila bottles in the parking lot after a Dave Matthews Band concert.

And HP got its act together.


And finally came the mind-boggling earnings miss from shareholder-friendly Lexmark.

On yesterday’s conference call discussing the actual earnings report, the Lexmark folks discussed their active share repurchase program: year-to-date the company has bought back 12.6 million shares at a total cost of $870 million—average price, $68.83.

Yesterday’s close: $39.69.

Negative “enhancement” to the value of Lexmark shareholders: $367 million.

In the case of Lexmark and its share repurchases, less would have been more. DuPont shareholders should hope its management has greater insight into its business than the folks at Lexmark.


Jeff Matthews
I Am Not Making This Up


© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

23 comments:

Ed said...

are you aware of any studies that look at this practice?

"when companies buy back stock it offsets the added shares from all those options grants and helps inflate the “Earnings per Share” calculation."

Alex Khenkin said...

From my amature prospective share buybacks are a total waste of the owners' (a.k.a. shareholders) money. They should only be contemplated when the price of the shares falls significantly below the book value (Graham's 1/3 safety margin would be a good start). Other than that the money should either be invested into the company growth or (usually better) returned to the owners.
Small Investor Chronicles

cdub said...

Why do companies go the "buyback through an IB" route? Why not just purchase them on the open market, or do it via a dutch auction?

whydibuy said...
This comment has been removed by a blog administrator.
whydibuy said...

I say next to " its different this time" , " enhancing shareholder value" is the most dangerous phrase to hear. It usually comes from a mgt thats lost and out of ideas to advance the enterprise. But its a good media blurb and it'll get lots of airplay. And in my experience it comes just before a long decline both in the co's fortunes and stock price. When you hear that, sell. Buybacks are another thing. Yes, many buybacks are not completed, but it makes a good media buzz. Thats what the press will run with and many times it'll produce a pop in the stock short term, which is just what mgt wants. But I've found buybacks are used for a red herring to take the spotlight away from poor mgt or a declining business. And interestingly, I've seem some mgt's, knowing no one reads the 10-k, announce a buyback while deep in the 10-k on pg 105 of mgt's discussion & financials it'll say " due to the leverage in the co's capital structure, we may have to sell assets, issue bonds, preferred stock or COMMON stock" WHAAAT! I thought they were buying it back! Thats why W. Buffett says he's read 1000's of reports. So he doesn't get taken in by a devious mgt.

Jeff Matthews said...

"cdub": DuPont is the second company I've seen buy back directly up front from an investment bank instead of buying over time in the market place. Radio Shack was the first.

The reason for doing it this way is that it's done all at once so the total transaction cost is probably lower; it immediately eliminates the shares from the share count calculation; it retires the shares and thus the company doesn't have to pay the dividends on those shares, so net net it's a faster return on investment...

There are probably other reasons and informed commentary is welcome.

The Unknown Professor said...

Many of the things said here are on point - there's a lot of evidence (studies done by pointy-headed academics like myself) that firms repurchase stock to manage EPS, and that many repurchases are never consummated (particularly for open-market ones).

However, there a couple of scenarios where a repurchase could enhance shareholder wealth. I started to lay them out, but realized that it was too long to put into a comment - so I made a post on my blog.

BTW - like the blog. Keep up the good work.

whydibuy said...

One of the best-or worst, depending on your point of view-was Lou Gerstner at IBM. Fred Hickey did an analysis showing that all Gerstner did was load up the bal sheet with debt to buy in stock and thus give wall street what it wanted, higher posted earnings. But, accounting for share shrinkage, IBM actually was in decline for all of Gerstner's reign. Without the buyback, 'ol Lou doesn't get any bonus and those options stay underwater. But he got his. Now IBM has to do it the hard way. The exchange debt for shares option is gone. Money has to be made the old fashioned way - through blood sweat & tears. Yes, buybacks can be prudent but its a rare event.

DaleW said...

Negative “enhancement” to the value of Lexmark shareholders: $367 million.

The company's investment time horizon isn't three months, I am sure. We'll see five years from now whether they made the right decision. This isn't a hedge fund, though -- how they did over a three month time horizon should mean exactly jack square to the board and shareholders.

On options dilution, it was 1.6% net last year. That's not agregious. The pre-tax value of equity they awarded last year was $63M and they bought back how much stock? I think they more than made up for the equity issuance.

Not that other companies don't issue equity stupidly and don't abuse their ability to do so, but I think you have the wrong suspect here.

Sam S. Park said...

I like your take on retiring shares to eliminate having to pay dividend on those repurchased shares. Buybacks can be analyzed in many ways, especially depending on size and method of the purchase. Sure some will say management is signaling positive outlook, reducing a large block of overhanging stock in the market, or using up its cash for the lack of better investments.

Du Pont’s buyback probably has some to do with those reasons, but I’d assume tax reasons have a lot to do with it. Corporate finance teaches us about the drawbacks of a double taxation (on corporate profits and then on dividends). We’ve seen companies do repurchases as an alternative to cash dividends for those double taxation reasons. Shareholders who sell those shares are then only subject to capital gains tax. If the company had distributed that excess cash as dividends, then its shareholders would have to pay taxes on those dividend payments.

Then again, if it’s not a cash story, and DD did this repurchase using debt, then it’s probably more of a leveraged recapitalization strategy. But that’s another story and would require some homework. You guys and gals should know where to look.

Prudent Investor said...

Dividend taxation has been slashed, at least for the moment, so I don't believe a bit it's about double taxation issue.

Second, money is cheap, so leveraging up to pay for shares repo is the THING in corporate finance nowadays, exactly for the wrong reasons.

Third, the MAJOR reason is that option holders DON'T GET A CENT if a dividend is paid. Upper management who is HEAVILY compensated in options are paid only if their options are in the money. Hence, the only way to pay for management salary and many instances without raising SG&A (such as CSCO) is through share repo.

So you see, share buy-backs IS NOT shareholder friendly in this scenario especially when management are overly optimistic in business trend and shares are generally expensive. In fact, share buy-backs should have been the THING to do 10-15 years ago when stocks were cheap. Right now, shareholders should question every intentions by management to enhance shareholder value via share repo.

Sam S. Park said...

Prudent Investor,

You know what... you're probably right. But dividends are still taxed at 15% for most individuals. And I doubt that low income individuals, who are taxed 5% for div payments, own any DD shares. Div taxes won't be completely slashed until 2008, which will return to normal income tax levels in 2009. I guess the tax consideration doesn't have the effect it did pre-2003.

Your "management payment" story makes alot of sense to me. You made some really good and valid points. Nice.

By the way, does anyone know if DD leveraged up to do this repo?

Sam S. Park said...

I forgot to mention that there could be tax (shelter) incentives by using debt. But you'd have to do some present value calculations and comparisons to see if this was the case. I wouldn't want to do that unless I had a lot of stake in the company. At any rate, I would have to agree with Prudent Investor that shareholders should be very skeptical about buybacks.

cdub said...

Amsurg (AMSG) also recently announced a similar plan. Does the company also profit from movement in the stock price?

Aaron Koral said...

So here's the 64,000 question for the board - in what instance would a share repo not be considered "skeptically" by investors when a company intends to enhance shareholder value?

Sam S. Park said...

Aaron,

There probably are some people here that could give you a million dollar answer... but certain things shouldn't be so easily accessible. I think most of the answers to your questions already reside within this blog thread. But if you want specifics, you should contact your investment banker or advisor that can handle your recent question.

I'm just one simple and humble person, however, I don't think we should abuse this free access to knowledge and information. My best advice to your recent question is for you to buy some books, take some classes or hire some company to handle your situation(s).

Then again, there may be someone who's willing to spill everything and really make education practically free. That's when I would acknowledge that this "new economy" is real. I suppose time will tell. Who knows... maybe someone here will give a great insight to your $64k question. My best friendly advise for you is to google some of your questions.

Peace out bro.

BTW - I have no stake in Google.

DaleW said...

So here's the 64,000 question for the board - in what instance would a share repo not be considered "skeptically" by investors when a company intends to enhance shareholder value?

When the repurchase price is far enough below the intrinsic value of those shares such that the return generated on that investment beats the opportunity cost of that capital.

Sam S. Park said...

That works, but there are others. It really depends on how it's done. It really can get too complicated, therefore my suggestion about reading some corp finance books. That's my two cents.

Aaron Koral said...

Hi Sam.

My question wasn't intended to elicit a definitive answer, really - I was only looking for others on the board, such as dale w, to share their opinions on the subject of whether any share repo would not be considered "skeptically".

I've read some books on investing (i.e., Graham & Dodd, Siegel, Damadoran, Maboussin and Rappaport, et al.). I can't say I've read any corporate finance textbooks though - the subject's a little too dry for me.

Reading some of the intelligent insights shared by posters like you, dale w, and btc, however, makes me realize how much more I have to learn about finance and investing.

I can't say that I know a whole lot about finance, but to paraphrase the Beatles old chestnut "[I'm] getting better all the time" as I continue to learn.

Here's hoping that your next trade(s) are profitable ones, and again, I appreciate your sharing the intelligent insights you have on finance and investing.

Sam S. Park said...

Hi Aaron,

I didn't mean to come off defensively to your question. I agree that this means of communication represent a great tool to share knowledge. I had just watched a CNBC segment on how bloggers have been causing some concerns of worry to corporations, and I was simply stating that maybe we should be careful with the contents shared. Perhaps I felt a bit guilty, but I suppose everyone should realize this new change, and that they should get used to this shift.

Aside from that initial concern, I was basically saying that a buyback meaning could really get complicated, and specifics are probably better obtained from textbooks. Sorry if I came off sounding like an a-hole.

To give you a straight answer to your previous question, I know some companies have leveraged up doing a large-scale buyback (in the form of a leveraged recapitalization). In such cases, one would go towards the privatization path to clean up its operating inefficiencies, while getting some tax breaks (remember, interest payments are pretax)... the explanation can get really long. But I hope this is enough for you to work with for now.

It's funny, but I've noticed that Jeff's post after my comment had some Asian innuendo remarks. I'm not sure if it has any correlation to what I've said or not, but then again, they were related to Japan and China... I'm Korean, so whatever.

Clyde Doggie said...

Interesting piece on this issue today, also names several other companies besides Radio Shack that have done this.
http://www.thestreet.com/_mktwrm/markets/matthewgoldstein/10250737_2.html

Sam S. Park said...

Clyde,

Good article link... I would say that article was an informative contribution to this thread of comments. It's all about making money... but for whom is the true question.

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