Monday, August 17, 2009

The Opportunity Cost of Thinking like Everyone Else



Back in the day—that would be nine months ago—when the once-bright world had gone dark for millions of home-flipping Americans and second-property-in-Spain-buying Brits, one significant repercussion of the housing collapse was being felt on American stock exchanges: corporate treasurers at literally hundreds of publicly-held companies who had once thought nothing of paying irrational premiums for their own shares in the name of Returning Value to Shareholders were suddenly watching those same share prices flicker by on their computer screen at half or more off the price they’d willingly paid with all the abandon of an Inland Empire home buyer not many months before.

And the reaction of those corporate treasuries was—like the Inland Empire home owner suddenly underwater on their mortgage—to freeze.

We pointed out one such example, a specialty chemical maker called Lubrizol that had purchased its own stock at $52.63 a share during the September 2008 quarter, but refused to touch the stock when it was being offered, in size, in the vicinity of $37 a share one month later, as we pointed out in a virtual column called “
Companies Bought High, But Won’t Buy Low” (November 3, 2008).

At the time, Lubrizol’s Treasurer, Charlie Cooley, explained the strange logic behind the company’s “Buy High, Don’t Buy Low” repurchase strategy as follows:

Fair question….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.

Far from being “methodical and systematic,” Lubrizol’s share repurchase program appears to have been more on the “mercurial and arbitrary” side, given the fact that a share repurchase was decidedly more attractive with the stock at its “suspended temporarily” conference call valuation of less than 6-times trailing EBITDA than at its “methodical and systematic” share repurchase valuation of nearly 8-times trailing EBITDA.

Now, if Lubrizol management had decided to “get back into a share repurchase mode” during the early March 2009 market panic, with its stock trading briefly at $25 a share, just below 4.5-times trailing EBITDA, we’d be nominating Lubrizol’s Treasurer for a spot in the Warren Buffett pantheon of Rational Investing.

But they did not.

Thanks to a sharp-eyed reader with something of a rooting interest in the stock, we returned to Lubrizol’s most recent earnings call—specifically the part where Mr. Cooley discussed the sources and uses of Lubrizol’s ample cash flow—via the indispensible StreetEvents:


Based on these assumptions, we project our year-end cash balance will be in the range of $800 million to $900 million. While our strong operating cash flow and first-quarter financing activities have provided us with increased liquidity. We plan to remain cautious in our approach to the use of our available cash.


It is reasonable to assume that we will hold excess cash for the foreseeable future, especially in light of the current environment of volatile commodity prices and uncertain demand. We do have the ability to pre-pay as much as $150 million of debt without incurring a penalty.

In fact, the company actually increased its estimated shares outstanding, thanks no doubt to management option grants bloating the share count.

As for share repurchases, Mr. Cooley said:

At this time, we have no plans to reinstate our share repurchase program.

Hey, having missed the stock at $35, and $30, and $25—and the last trade occurring at $61.69 a share—who could blame them?

But we’ll make a bet here.


In the currency of one of our old hedge fund friends, we’ll bet dollars to donuts the next time Lubrizol buys stock, it’s not at $25, $30, or $35—rational as those prices proved to be. We’ll bet it’s at a multiple of one or all of those prices.

And Wall Street’s Finest will applaud them for “Returning Value to Shareholders.”

Ah, the opportunity cost of thinking like everyone else!




Jeff Matthews
I Am Not Making This Up


© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only 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, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

10 comments:

Kevin said...

I'm probably stating the obvious here, but I'm sure more issuers would have been buying back their stock at bargain prices - if they could. And that's a big if. The problem with doing so is that, at a time when the market is telling you your company is worth half of what it was 6 months ago, you're likely not going to be in a position to deploy cash the way you'd want to - especially if you're more than even a little bit leveraged. In such a case, you've likely just seen all your liquidity vanish, save the cash you have on hand. Do you really want to buy back stock when you don't know whether your banks are going to be there so you can make payroll? On top of that, you've just seen short term credit markets freeze up like they've been given a lethal shot of sodium silicate. It's not unreasonable to be conservative in that kind of environment.

For those with healthier balance sheets, they very well may be building war chests to take advantage of the depressed market with strategic plays.

Regardless, isn't it management's responsibility to provide superior returns on a company's "excess" cash by either (a) investing in the current business, or (b) buying and integrating new businesses. If the opportunity isn't there, why not return cash to shareholders? That must have been the conclusion Microsoft reached a couple years ago with their special dividend. Which was doubtlessly a better use of cash than a purchase of Yahoo! at $30 a share. The point being, sometimes returning cash to shareholders - either through a dividend or a buyback program - is the best use of a company's money.

Anonymous said...

I love these examples of "returning value to shareholders." May be they are cherry picked (I don't look into all the statements of that kind out there), but from the few that I saw outside of this blog, they were just as disastrously timed. Too bad their own options are not tied in to performance of their "investments."

And Kevin seems to be generalizing even though we have a clear cut case here. The company had cash, the stock was low, if they do any sort of repurchasing,it was the time.

As far as Microsoft's one time dividend, I recollect it had less to do with "returning value to shareholders" and more to do with some massive tax advantage that was about to go away.

Mark said...

This is typical of the conversation I’ve had with almost every CFO I’ve spoken with in the last six months:
“What’s your philosophy now on share repurchases?”
“We’ve put it on hold. The world is too uncertain.”
“Does that mean you’ll resume repurchases when the world is more certain and your share price is a lot higher?”
“Yes.”
They don’t even detect the irony of what they’re saying. It’s uncanny. They’re all saying it.
I’m amazed that executives don’t get it when it comes to share repurchases, even though they’re paid millions at least in part due to their capital allocation skills. Most management teams seem to think that share repurchases are always value-enhancing regardless of the price paid. But buying your own stock at high prices is the same thing as buying any other asset at a high price.
I can reluctantly tolerate a management team who always buys stock back, and one who never buys stock back. However, I can’t tolerate those who only buy stock back at high prices when there’s “visibility”. Unfortunately that seems to be the vast majority of them. Yes, there are some companies where survival was in question, and they needed to go into cash preservation mode when stock prices were at a bottom. But there are numerous companies with good balance sheets that froze their buybacks because the world was uncertain. This seems particularly true in the tech world where some of the balance sheets are ridiculously strong.
Does anyone know of a decent-sized company that resisted buying back much stock in the years and quarters leading up to 2H 2008, then took advantage in a meaningful way in Q4 2008 and Q1 2009? I did a quick screen of the S&P 500 looking for such companies, and at first glance, I’m not sure if I see any.

Jeff Matthews said...

Mark,

I'm not sure how you define "decent-sized" company, but Rex Stores, which we wrote about in April 2008 after the CEO refused to buy stock back in the $20-25 range and discussed his reasons on an earnings call at that time(see "How to Buy Back Stock: Not “Just Because We Can”"), did repurchase stock this spring below $8 a share, as per the company's June 9 conference call.

I am struggling to come up with another example: all suggestions are welcome.

JM

brian said...

Jeff,

You have to look at share repurchases from the perspective of the holders of corporate options aka senior management, not the general stockholder. It is entirely rational for management to purchase shares at a high value as it allows execs to exercise their options at that inflated price. when the share price is low, why would management buy back stock if the execs options have little or no value?

Anonymous said...

The point that is missed I think is that the companies have great timing at two different times - the first is buying stock back when their price is high and the second is granting options when their stock price is low. Could there be some correlation between those types of skill?

Just need to chalk it up to an opportunity lost.

buzzp said...

Jeff - this is completely off-topic and I apologize in advance.

Earlier in the summer, from late June through July, you wrote at length about two parking terminals at JFK. Like at least one other long-time reader, I was concerned that your take and your tonality were not "in sync" with your otherwise excellent commentary.

From what small knowledge base I have of your world, it appears your facts are usually OK - I haven't fact-checked you in the past, but I didn't feel it was necessary. In this case, as I have just returned to the hot & sticky city, I read all three posts in one sitting and your "facts" jumped out at me as assumptions. So I did two minutes of Google:

Terminal 4 parking is operated by the same company as Terminal 7 parking. In fact all parking on the Port Authority airports is operated by the same company: Five Star Parking, a division of privately held L&R Group of Companies, headquartered in Los Angeles. L&R appears to be the Berkshire of parking, with airport contracts all over the place.

So your basic analysis that there was a State Senator's brother-in-law skimming from one lot and not the other appears to have a rather shaky foundation. (This is not to say that State Senators' brothers-in-law are not known to have their fingers in the till.)

I have come to expect a more fact-oriented analysis from you, and you have in this case weakened (to me) your argument in those three posts.

You can call 5 Star's NY regional office at (718) 244-4168 and complain to them about the apparent difference in operation of the two parking lots; if that doesn't work, David Damus is CEO of L&R and he might appreciate hearing about a customer's concerns.

Jeff Matthews said...

Buzzp...excellent comment, thanks for the fine leg-work.

Of course David is welcome to post here.

In the meantime, I have to make a pick-up at Virgin on Friday, and will do everything in my power to avoid the parking!

JM

buzzp said...

I don't know David Damus - his name just popped up on a Google search. But his e-mail is ddamus (at) tlrgc (dot) com if you want to send him your thoughts - me, I live in the city and always take a car service to JFK, even when I'm picking someone up - saner and less wearing on the body, believe me.

Aaron said...

Jeff: Where's a great capital deployer like the late Dr. Henry Singleton of Teledyne when you need him?

(hat tip: James Grant, author/publisher of Mr. Market Miscalculates and Grants Interest Rate Observwer)