Wednesday, November 01, 2006

Well Excuse Me

It isn’t easy being skeptical, at least in public.

A few weeks back, I made the mistake of asking what was perceived as a not-friendly question at a company breakout session during one of the many healthcare conferences we attend each year.

Conferences are a great way to hear from a lot of companies in a short period of time, swap ideas with friends and maybe find something new. I spend most of my time in the breakout sessions, because that’s where you can take the measure of management and also hear what other people are worried about or interested in.

It was in that frame of open-mindedness that in late September I stood in the back of a packed breakout session and listened to a management team explain its recent earnings stumble to the disappointed-but-hopeful shareholders in the crowd.

The company in question is a formerly high-flying consolidator in the field of drug discovery tools and cell culture material for biotech and pharmaceutical companies—and until late last year management could do no wrong , snapping up $1.5 billion worth of other players in the field, reporting quarter after quarter of positive earnings surprises, and watching its stock triple in the process.

The good times, and the stock, peaked last year, prior to several inconsistent earnings reports, and was well below its $88 peak when the company reported a bona fide earnings miss this August—a miss that caused one of Wall Street’s Finest to ask, during the ensuing conference call,“What the hell happened?”

I am not making that up.

Here’s the full quote:

The first question, I'm just curious at what dramatically changed from the time that you had your analyst day in June…. Certainly when we were at the analyst day, I think we spent a lot of time drilling down onto your visibility into the back half of the year, and I think I will speak for a lot of the people on the phone that want to know what the hell happened?

Now, the company in question didn’t get to be a Wall Street Fave by fumbling conference calls. And sure enough management spent a good portion of the call talking up a $500 million share buyback the company had announced simultaneously with the earnings miss.

Such share buybacks are an old technique by which companies take the sting out of what we on the Street call a stock that is—in the precise, technical jargon of the professionals that we are—“blowing-up” as a result of the company “puking the quarter.” And a half-billion dollar share buyback is, at least for this company, pretty big.

But what made it stand out, at least for me, was the eagerness with which management shared the details of when and at what price the buy-back would take place.

See if you can spot what appears to be—and I do not believe I overstate the case—an implied guarantee that the stock would go up some time in the future following the buyback:

Now I would like to briefly cover the share repurchase program that we announced today. We see the buyback as a means of returning excess cash to our shareholders and enhancing our return on invested capital. The current stock price is an additional factor in our decision since we're confident in the future of the Company and therefore know that we will get an attractive return for purchasing the stock at this price [emphasis added].

And to make it seem even more like a no-lose proposition, the CFO more or less said the company would begin buying its stock at once:

We have a significant amount of funds currently available to do this buyback as well as acquisitions. With our cash balance of over 700 million plus the current revolver and the addition of the second half free cash flow, we have plenty of funds at our disposal to execute a significant portion of the buyback immediately as well as move quickly on acquisitions as opportunities arise. [Emphasis added.]

Whether all this was a bald attempt to prop up the stock or not, I have no idea and take no side, but the implication was clear: the company would spend a “significant” portion of $500 million buying stock real quick.

This seemed to me roughly equivalent of an over-excited Grad Student hell bent on making his name at Binion's Texas Hold ‘Em table flashing his paired aces to the other players and going "all in" before the Flop, the Turn or the River. Anybody at the table with half a brain would immediately fold, leaving Mr. Paired Aces nothing to collect for his great hand but the lousy blinds.

After all, the very act of announcing the company’s intent to buy several hundred million dollars worth of stock ASAP would likely hold up the stock price higher than where it otherwise would trade, thereby unnecessarily raising the cost of the share repurchase and lowering the return to shareholders.

Nevertheless, the company did show its cards. And in case anybody had missed them, the CFO flashed them again, during the Q&A session, repeating the company’s eagerness to begin buying stock:

It was authorized at our most recent Board meeting last week, and we're in the blackout period. We'll be in the blackout period until Sunday, and at which point we would be free to start executing buyback. As we've said before, we're running through the mechanics right now, but we would do a substantial portion of the $500 million authorization relatively soon [emphasis added].

Now, I admit to being a little wary of managements that try to keep Wall Street’s Finest on their side with happy talk and spin control.

But, hey, if I'd been long a stock that was no doubt being referred to by disgruntled portfolio managers as—using, once again, the precise technical term—“a pig,” I’d be rooting for the company to buy every share it could get its hands on, price be damned, if only to give me a chance to get out.

(It may surprise people to read this, especially those who put their life and heart and soul into a company for the better part of their natural lives on this planet, but most institutional investors—hedge funds especially—could not care less what a company actually does for a living and how it provides for its employees and their families and their children: most of 'em just want the stock to go up. And if it doesn’t, they get rid of it like an old bag of lettuce turning brown and wet in the back of the frig.)

And so it was that two months after the Paired Aces conference call, I decided to attend the Q&A session of management’s appearance at a healthcare conference, just to listen.

And it was during the course of a discussion about the $500 million share repurchase that management allowed as how the company could buy stock up to a price as high as $80 a share.

I looked at my Blackberry: the stock was trading hundreds of thousands of shares, at a price near $63.

This boggled the mind.

Why on earth would a company authorize a repurchase “up to” eighty bucks a share when it could have all it wanted in the low $60s?

Aside from making the poor shmucks who’d owned the stock at $80 feel like they had some shot at getting their money back, I could see no reason to slap a silly number on something as serious as the allocation of half a billion dollars' worth of shareholder’s capital.

What, I wondered, were they smoking?

So I asked them that, in a slightly different way:

“How’d you come up with $80?”

Management smiled tightly and more or less shrugged, saying something to the effect of this:

"That’s what we decided."

So I asked it again:

“But how did you get $80? Were you looking at return on capital? Earnings dilution? What was the analysis?”

Now, anybody with six months in this business could have answered that question. My dog Lucy could have answered it, if she could talk.

After all, most public companies at some time or other buy back stock—some to offset option dilution; some to take advantage of market weakness; some to shrink their capital base; some to prop up the stock; some to re-allocate capital in the absence of better reinvestment opportunities; some for all the above.

And when they buy stock, they usually consider two things in determining what price to pay: they look at the point at which a repurchase becomes dilutive to earnings (based on the implied cash on cash return of a repurchase as compared with keeping the money in T-Bills) or the alternative returns from making an acquisition with the dough.

Something, in other words, that is rational and easily defined.

But you would have thought I had asked these guys for their opinion on the Combined Uniform Theory of Relativity, or whether they were, in fact, the bright boys responsible for the “intelligence” that Saddam had WMD. Or the ones who thought of giving the CBS anchor job to Katie Couric.

They sort of shrugged and cleared their throats while a kind of embarrassed silence descended on the room, keeping anybody else from following up on the topic.

Finally, a fellow sitting near me in the back turned and said in an angry, sharp voice:

“The stock traded at $80 not too long ago, you know.”

Since he was clearly one of the poor schmucks who had owned the stock at $80 and was rooting for the stock to get back there, I didn’t say what I was thinking, which was:

“So let me get this straight: the company should pay $80 just because that’s what some idiot thought it was worth last year?”

Instead I let it go.

You can’t win asking a perceived-unfriendly question in a room full of investors who know they’re stuck in a pig but don’t want to admit it.

Which is why it wasn’t all that surprising when the company "puked" another quarter just last week and the stock "blew up"…at the same time management announced it had spent almost $300 million of that half-a-billion authorization to buy stock at $61.

Now, you might think that with the stock dropping below that price on Friday, the company would be delighted to have the opportunity to spend the rest of the $500 million at a lower price.

After all, if they liked it up to $80 and paid $61, they must love it below $60, right?

Well, not exactly.

“We expect to continue to be buyers of our stock, although the level of the buyback will depend on several factors, including share price, other cash requirements, and expected cash generation.”

In other words, this time they aren’t showing their cards yet.

And they want to see the Flop—and maybe the Turn and the River—before they go “all-in.”

© 2006 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. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


CapitalAllocator said...

I hear you jeff...too many "hopeful" investors in IVGN. But any time Wall Street's finest downgrade a stock enmasse, I usually like to take a look - it's a buy!

SiamTwin said...

this was one of your best columns to date, in my opinion. thank you.

MyDailySlice said...

Yet another reason for LBO's.

Keep up the great posts!

Gone to the blogs said...

You sound like me...I love being "that guy" in breakouts and small group sessions. Management's response (or lack) can be hugely informative.

On another topic, it scares me that so many executives think that buybacks somehow improve ROIC. Properly calculated, the denominator of the ROIC calculation is indifferent to capital structure tricks (that's the whole point). And the numerator uses unlevered income, so there's no effect there, either. So what the hell? They must mean ROE, I guess. But even then, buybacks do not guarantee higher ROE. It's frustrating to hear crap like this from "too smart by a half" managers.

bgthej said...

Echo the opinions on the quality of this post Jeff. Management teams should have no control over stock buybacks, should be left completely in the hands of the board or someone that is not fearful of losing their jobs. Things like this are just slightly better than backdating of stock options, which too many have dismissed despite it representing management teams essentially stealing from shareholders.

Woodrow said...


I was at that breakout and remember your questions word for word. Had I known it was you asking, I would've come up and introduced myself.


Sam E. Antar said...


You questions, professional skepticism, and healthy cynicism are quite appropriate.

As a criminal my main fear was the kind of questions you are asking in your post.

However, it is often the case that despite the issues you raise that many investors and analysts are too quick to accept management's spin.

While criminals fear good questions investors and others often ignore their bad answers.


Sam E. Antar (former Crazy Eddie CFO and Ex-felon)

jmf said...

thank you from germany!!!!!!

what a great post.

Gnanakan said...

Good Post. This would've been great if you posted it before IVGN earnings. However this whole post raises an important question.

Why do you NOT mention the name of this company (IVGN) yet give so many detail about it so that anyone could easily figure out what company you're talking about?

This is even more puzzling considering that most of your posts are straightforward and mention company names and even officers specifically.

If you had a position in IVGN (most likely short) then ethical standards would dictate full disclosure. This would mean that even if you refuse to explicitly name the company you would have the ethical responsibility to disclose that you had a position on the table.

Here, I'll give you an example. I'm currently long SGU and a small amount of DIVX and short CHS and have no other positions...

See it isn't that painful.

Cramer, everyone on realmoney/insight, and others do it.

You can too.

Anyways, a big P.S. to everyone to go out and vote democrat so that we can stop this country from circling the drain.

Jeff Matthews said...

"Gnananakn": The name of the company was irrelevant.

It was not a comment on that company, the name of which you so cleverly deduced, nor on that company's stock price or whether an investor should be long or short that particular stock.

It was, rather, a comment on the disenguousness with which public companies and Wall Street's Finest alike pursue that which is in their own interests, regardless of economic value.

Congratulations on guessing the name.

stealthelephant said...

IVGN has done this before and under different management: blow the quarter in a spectacular way after a much-hyped analyst meeting. As far as I can remember following this stock, the problem for investors has been transparency in the consumables piece. Since the end-users of IVGN's consumables are thousands of bench top scientists with universities, pharmacos, and biotech companies, predicting growth rates from quarter to quarter is nigh impossible. And yet, since IVGN began consolidating the industry, different managements have tried to convince investors that the company is a high-growth company with predictable earnings. Cell culture business aside, the consumable business is a use-as-needed business. With all the sales data management has at their finger tips, they will ALWAYS be flying by the seat of their pants to set growth rates for this part of the business. It is only transparent at the point of sale. They have never had a good line on earnings streams for this biz, even a quarter ahead (ex acquisitions, mind you). I wish I could say I was short. Always, always be wary of high multiples in the tools biz. They don't persist like the way they do in med devices or biotech. On another note, thanks for posting Gnanakan's comments. He is an idiot.

Aaron Koral said...

Jeff - Just a question and a compliment:

A) Using a present value analysis on IVGN with $80 as the future value, five as the number of years, and $58 as the approximate starting value (i.e., the share price), one gets an implied growth rate of 6.7%.

For those who wonder how I got my figures, you can do it yourself using a Present Value formula, with the following variables:

PV = FV/(1 + r)^n, where PV = Present Value, FV = Future Value, r = growth rate, and n = number of years.

The thing which bothers me is, how do analysts square their 15% long-term growth rate estimate (you can see this information on Yahoo Finance under Analyst Estimates for IVGN, and I am not making that up) with the implied long-term growth rate the company is suggesting with it's $80 share price target?

Beats me, but then, I could be wrong in my analysis.

B) Your post Jeff is instructive in suggesting that not all share buyback announcements are the same. As an investor, one should investigate very carefully the motive(s) of companies buying back its stock.

I would think that the balance sheet, as well as Notes to the Financial Statements, are good "tells" (i.e., reduction in equity common over a number of quarters) of whether a stock buyback is truly significant, despite a company's claims of "under-valuation".

Here's hoping your next trade is a profitable one...