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Understanding share buybacks
Companies who are cash rich have generally three options: invest in expansion, distribute higher dividends or engage in buying back their own shares. The general theory is that a company would deploy surplus cash into buying back its own shares if its business is very profitable (high RoI and RoE) - so profitable that its future expansions are unlikely to match existing profitability. So profitable that its shareholders can't deploy distributed dividends more profitably than the company's existing profitability. Buyback in this case is the best course of action for shareholders.
In a world awash with low cost debt and slow growth in underlying businesses, corporate finance wizards have given a whole new meaning to share buybacks. Its no longer about the best utilization of shareholder's funds - its about finding ways to boost your share price even when profits are slipping.
Lets work through an example to understand the latest game in corporate finance.
Company A has a profit before interest and tax of $100,000 in year 1, which translates to a PAT of $70,000. EPS works out to $70, based on a total of 1000 shares outstanding. Lets assume for the purpose of this example, that its PE remains constant over the next 3 years, at 15. Based on year 1 EPS, its share price is $1050.
As year 2 rolls on, the management realizes that profits are not growing, and in fact may dip marginally. The management's compensation is heavily dependent on keeping its share price growing year after year, and the generous ESOPs too depend on maintaining its share price growth. When they give up trying to boost growth of underlying business, they come up with an idea of buying back 10% of total shares, by borrowing at the prevailing low cost of say 3%. At a price of $1050 per share, they buy back 100 shares, from borrowed funds of $105,000. Year 2, as they forecast, ends with a marginally lower profit before interest and tax, signifying sluggishness in the underlying business. Interest cost on money borrowed for the share buyback further eats into profits, resulting in PAT coming down from $70,000 to $67,095.
At a constant PE, this would normally mean a lower share price. But the impact of the share buyback is such that because the number of shares outstanding has reduced faster than reduction in profits, its EPS actually grows from $70 to $75. Magically, the share price goes up rather than down, at the same PE. The management's compensation plan remains immune to underlying sluggishness in its business.
Action replay in Year 3. Another year of no business growth. Another year of potential pressure on the share price. Another round of share buybacks financed by cheap debt. Profit after tax drops further, but EPS grows anyway. So does the share price, at constant PE of 15.
Company management has found a new way to boost share price even when the business is not growing. Alls well that ends well? Not really. Debt on the books is now twice the annual profits - it needs to be repaid at some stage from shrinking profits. And, if interest costs increase when rates start rising, the whole equation goes for a toss - because profits will start shrinking faster, creating a need for even larger buybacks at even higher amounts of debt. It's a game that does not have a happy ending - except if the underlying business starts picking up momentum rapidly, and incremental profits are generated to pay down the debt and boost the share price - this time for the right reasons. For that to happen, you need strong economic growth - which continues to elude the developed world.
How big is this issue in the US?
Ok, so we know that some companies in the US are in a way manipulating their share price through share buy back programs. The key question from a market point of view is whether there are only isolated cases or is this an epidemic.
The bad news is that the quantum of money spent on share buybacks is now at the same level as the 2008 highs - which marked the heights of several excesses in the US financial markets.
About 27% of the companies listed in the S&P 500 Index reduced the number of shares by 4% from the year ago period. This boosted their earnings per share by a like percentage. Yet earnings of companies witnessed a 7% drop in the first quarter. While final figures are yet to come, $142.5 billion has been spent on buybacks in the last quarter alone. The real comparison is with $157.8 billion in the second quarter of 2007, the $172 billion in the third quarter of the same year and the $159.3 billion in the first quarter of 2014.
According to Reuters, of the 3297 non-financial companies whose shares trade publicly, nearly 60% have initiated share buyback programs since 2010. Further, in 2014 the amount spent by companies on share buybacks exceeded the combined net income of those companies - a clear pointer to debt financed share buybacks.
In the last year for which data is available, companies purchased a whopping $520 billion worth of shares. According to recent research done by HSBC, US companies have collectively spent, in the last 5 years, a staggering $2.1 trillion in share buybacks. This is not then a case of a few companies attempting some window dressing - it seems to be a pervasive phenomenon that's spread across corporate America.
What's the end game?
There is now growing evidence that markets are beginning to discount this kind of window dressing. There's a lot that has been written and analyzed recently on the huge buyback programs of Apple and IBM - two US giants - and how they have failed to deliver the financial magic of ever increasing share prices despite sluggish business growth. Both companies ran huge buyback programs, which ultimately failed to lift their share prices.
Another angle, which the earlier mentioned HSBC research explored was a very interesting one: corporate share buybacks have emerged in recent years as the biggest buyer of stocks in the US market. As the law of diminishing marginal utility finally seems to be setting into corporate share buybacks, companies will start cutting back on these programs which will suddenly look very expensive. What then will happen to the US market when its largest buyer stops buying?
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