Monday, November 03, 2008

Companies Bought High, But Won’t Buy Low


Regarding our uses of cash in the quarter, capital expenditures were $49 million. We paid out dividends of slightly over $21 million and we repurchased 475,000 common shares for $25 million….

While we believe we have access to ample liquidity, we think it is prudent to so suspend our share repurchase program for the time being.

—Charlie Cooley, Treasurer, Lubrizol, October 30, 2008


Sharp-eyed readers who do the math implied in the quote above ($25 million spent buying back 475,000 Lubrizol shares = $52.63 per share) and then check the Lubrizol share price on their Google Finance ($37.58 last trade), will no doubt scratch their heads at the bizarre logic contained in the above commentary from Lubrizol’s treasurer.

Lubrizol happens to be a sleepy specialty chemical maker with a decent franchise in fuel additives. As the price of crude oil tripled in the last couple of years, so Lubrizol’s cost of goods soared, crimping margins as well as the recent stock price.

Yet now that Lubrizol's share price has declined along with everything else in this fear-crazed environment, the company is saying “We bought our stock at $52.63 a share, but we will not buy stock at $37.58 a share.” (For the record, Lubrizol shares traded as low as $34.25 and as high as $38.39 on Friday, when the statement was made.)

Fortunately, after several years of being asleep at the proverbial switch, Wall Street’s Finest are spotting the fallacy contained in the inherently illogical notion that companies who bought their shares near their all-time highs a few short months ago—under the “returning value to shareholders” mantra—are too scared to buy the very same stock at far lower prices today.

In fact, one of those Finest asked exactly the question of Lubrizol management that all such former members of the Returning-Value-To-Shareholders Club should be asked.

We reprint the dialogue courtesy of the indispensible StreetEvents:


Jeff Zekauskas - JPMorgan - Analyst

And lastly, you said that you bought 475,000 shares…and you spent $25 million, so you bought them at $52 a share. Your outlook is I guess the same as you thought it was, but you are suspending your share repurchase now that the stock is at $34. Do you think that that is -- do you think that that is a prudent thing to do?

Charlie Cooley - Lubrizol - SVP, Treasurer & CFO

Fair question. And as you know, Jeff, we have been asked this question during the course of the year, asking why our share repurchase program has been as kind of methodical and systematic as it has been. We have never viewed the share repurchase program as primarily being a tool of making a call on our share price. Rather we see it as a way of balancing our use of cash and adjusting [our] capital structure….


This is all about maintaining the strong financial help that we have enjoyed for years. So it is suspended temporarily and we will look for an opportunity to get back into a share repurchase mode.


We’re not sure exactly what Mr. Cooley meant by “balancing our use of cash and adjusting [our] capital structure.”

We think it means, “We bought high, and now we’re too scared to buy low, but we don’t want to say so on a conference call.”

Other interpretations are welcome.


Jeff Matthews
I Am Not Making This Up


© 2008 NotMakingThisUp, LLC

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 investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.

16 comments:

Mark said...

There is no easy answer to this problem. When business is great and a company is minting cash, it suddenly becomes extremely vulnerable to activist shareholders who demand either a "special dividend" or a share-buyback of some sort (rather than just letting the cash sit on the books or, even worse, going out and blowing it on a bad acquisition). Thus, what is a public company in such a cash-rich situation supposed to do (as "just say no" is unlikely to work)?

tsb said...

Jeff,
I am primarily a REIT/REOC analyst, so I the decision to pay dividends is often moot for the companies I track. One strategy being increasingly employed by REITs combines a regular divided to return capital on the predictable portion of earnings, along with one-time dividends to return cash when the company makes less predictable gain income.

I am pondering if this strategy would have value outside of REIT land. One of the biggest problems I see (and you frequently point out) is the inability of many management teams to use their brains in capital allocation decisions. Would it be more valuable for shareholders to pay dividend tax in order to avoid stupid buybacks? If so, the blended regular/special dividend policy allows management to manage expectations along with rewarding the shareholders for lumpy, but growing earnings.

Anonymous said...

I honestly think this management team doesn't understand why overpaying for shares is the exact opposite of what you want to try to do.

Christopher Y said...

Maybe just a move preserving liquidity just in case their revolving lenders can't fund?

Looks like they have Citi, Wachovia, ABN, Keybank, and Fifth Third in the revolver.

Jeff Matthews said...

Mark asks a great question: what is a public company supposed to do when business is good, cash is flowing freely and some activist is pushing for a Stupid Buyback or Special Dividend?

My opinion is, tell the activist to either make a fully funded bid for the company if they really feel that way.

Mark's scenario is precisely why companies like HMA, Dean Foods, Cracker Barrel, etc etc got too leveraged at the wrong time: they didn't "just say no"...they said, "okay, we'll do it ourselves."

And here I postulate a reason why companies should consider Class A/B structures: so managements with long-term goals can tell predators to stuff it.

Two years ago I asked a Class A/B CEO whose stock I owned if he wasn't worried some big private equity player wouldn't buy up his stock and then push for a deal. He laughed and said, "They'd own a non-voting stock, and we'd tell them 'Thank you for buying our non-voting stock, but we're going to do what's in the best long-term interests of ALL the shareholders.'"

I continue to think the Class A/B structure is underrated, and the balance sheets of Cracker Barrel, Dean Foods, HMA and others are proof positive that responding to calls for "enhancing shareholder value" don't necessarily mean "in the long term."

Still, there are alternatives out there--as tsb correctly points out.

JM

Jesse said...

It seems that what they are really doing is saying that they don't even look at the share price when they decide whether to buy back shares. Stupid, of course, but they are trying to say that when they have extra capital that's how they return it, regardless of share price... Of course when they have extra capital the share price will always be expensive so it's a self defeating strategy... same argument as punting on 4th and 1 in the NFL... math says it's bad, but you won't get fired for it because it's what everyone else does.

Mark said...

In response to Jeff's suggestion of creating a dual-class (i.e., "supervoting" class of) stock, I believe that this can only be done with shareholder approval. I think that this would be impossible to achieve in this day and age, unless the proposed "supervoters" already controlled the company, in which case the requirement for this kind of stock would be moot.

The real answer should be that management must convince the shareholders that holding on to (at least a chunk of) that cash for a rainy day is the right thing to do. If the shareholders still demand the buyback (or a "special dividend" of some sort), well, they own the company and they're entitled to do that. Those (more conservative) shareholders who disagree are free to sell at any time.

invstmnt said...

This is an interesting topic. Time after time I see otherwise "good" companies injured by what Warren Buffett calls the "institutional imperative"; eg, you guys in operations are doing a great job but we've got to do what the investment bankers are telling us and do what our competition is doing; and buy back stock at whatever price. Hell, it will never hit the income statement and will boost our EPS irrespective at what price we buy back.
Buffett actually has an unwritten rule that he would do everything he could NOT to buy back Berkshire stock at all; even when he thought it was cheap, because he feels that in his position as steward of the owners' assets, he could be putting owners at a disadvantage through purchases using his inner knowledge of current company value.
There are many "Lubrizols" out there.
One is the great company Caterpillar. Over the last 3.5 years (ending 6/30/08) it has been cranking out some fantastic earnings. But the financial analysts in the exec wing over that period decided to destroy value through share repurchases, ranging from $50 to $72 per share.
At the current $39/sh that "investment" is underwater by $3.5B, which would wipe out all of 2007 earnings if it could be run through the Income Statement.

Anonymous said...

Seems to me that something missing from the discussion is that the definition of "cash rich" changes at market speed. LZ is not exactly sitting on a fortress of cash, with the prospect of considerably higher borrowing costs in the future.

invstmnt said...

This is an interesting topic. Time after time I see otherwise "good" companies injured by what Warren Buffett calls the "institutional imperative"; eg, you guys in operations are doing a great job but we've got to do what the investment bankers are telling us and do what our competition is doing; and buy back stock at whatever price. Hell, it will never hit the income statement and will boost our EPS irrespective at what price we buy back.
Buffett actually has an unwritten rule that he would do everything he could NOT to buy back Berkshire stock at all; even when he thought it was cheap, because he feels that in his position as steward of the owners' assets, he could be putting owners at a disadvantage through purchases using his inner knowledge of current company value.
There are many "Lubrizols" out there.
One is the great company Caterpillar. Over the last 3.5 years (ending 6/30/08) it has been cranking out some fantastic earnings. But the financial analysts in the exec wing over that period decided to destroy value through share repurchases, ranging from $50 to $72 per share.
At the current $39/sh that "investment" is underwater by $3.5B, which would wipe out all of 2007 earnings if it could be run through the Income Statement.

Anonymous said...

Too many companies are in dire straights right now because they simply cannot raise any debt capital, at any price. Because of this, there is every incentive to limit every single penny the company is paying out.

It is possible to recognize the boneheadedness of prior decisions without coming to the conclusion that they should be doing the same thing today.

Jared said...

-- During the third quarter of 2008, FCX purchased 6.3 million shares of its common stock for $500 million (average of $79.15 per share). Approximately 23.7 million shares remain available under the Board authorized open market share purchase program.

The CFO later stated that further share repurchases were not part of an immediate plan. In this case the declining global demand for Copper and Moly may justify Freeport's fear...unlike Jeff's Lubrizoil example in which the fundamentals are stable with lower cost of goods.

This example should make anyone a bit fearful about how fast the world has changed in 3 months.

-looks like they are using a stop loss order, if only I had....

Anonymous said...

There is an easy answer. Companies should be able to come up with a realistic value for the company. If the stock is below that value, then buy it. If it's not, then hold onto the cash. The problem is that the BOD of most companies include people who dont know enough about either running a company or finance. Every few years there is some market dislocation that would represent actual buyback value. If some idiot comes along and buys the company for more than it's worth - so much the better since its the shareholders who benefit. Management of companies that bought their stock back at the peak of 2000 or 2007 shouldn't be running public companies if they had unrealistic expectations of the true value of their company. Cl AB can provide some protection, but it doesn't protect against incompetent management. The other option for the cash btw is to reduce debt or increase dividend.

Anonymous said...

Jeff, perhaps you can give specialty insurance firm Assurant (AIZ) a NotMakingThisUp Gold Star for suspending its buyback program in September 2007 and *resuming* it today, November 6, 2008.

They suspended it because they were subject to an SEC probe into a whopping $8 million accounting error from 2004, so they may not be as smart as they appear to have stopped a buyback right around the market peak. Still, they were careful to note that the SEC probe is not completed. Perhaps having one's stock on sale is enough to let AIZ's buyback actions speak louder than words.

Dutch Tender said...

iaci expedia comcast and liberty interactive are other companies that liked to buy high and not buy low....

Kurt Osis said...

Jeff:

Have considered the rise in the value of the dollar due to the current liquidity crisis? While the share price has decreased in price it may not have increased in value relative to the potential alternative uses of the cash. Which is so say, if they can buy the equity of a British chemical maker it may make more sense to use the cash for that given the depreciation of the pound. Similarly they might build a new plant now that they have greater pricing power over the suppliers of infrastructure.

Simply put the way to preserve the value of the equity they have already purchased is to raise as much CASH as possible. This is why we see share issuances at market lows. Think of share issuance as a short sale to hedge against further decreases in the share price by increasing the company's cash position!