Pity poor executives with profits too high. It’s hard for many American companies to decide just what to do with all that excess cash. Should they please income investors and raise dividends? Go on an M&A binge to grow the business? Pay down debt?
Last year corporate America chose all those paths, but more than ever before they also took another route – the stock buy-back. Altogether some 1,100 US companies announced stock repurchases, worth within a hair’s breadth of an amazing $1 trillion of common stock.Despite this record-setting pace, opinion is mixed about the virtues of using corporate cash to buy back shares. ‘In the predatorial 1980s, buy-backs were a defensive measure,’ says Michael Metz, chief investment strategist at Oppenheimer & Co. ‘Now companies with excess cash have little to do with it except repurchase stock. Debt levels are moderate and a slow growth economy means investment opportunities are even more scarce. Moreover, shareholders believe they get more bang for the buck with buy-backs than with higher dividends; institutions are fully behind the buy-back trend.’
Metz’s positive view of buy-backs does not go unchallenged, however. John Rutledge, vice president of equity research at Boston-based Loomis, Sayles & Co, doesn’t like buy-backs unless there’s a good reason for them, such as a depressed stock price. ‘I prefer a more active use of funds,’ says Rutledge. ‘When management reinvests in the business instead of buying back stock, it tells investors it sees growth prospects.’
Rutledge’s speciality is technology companies, including IBM, which last year spent $4.9 bn on buy-backs while leaving its quarterly dividend of 25 cents unchanged. Loomis & Sayles, which manages around $48 bn of assets, holds 1.5 mn IBM shares and is looking at an increase in stock price to date of less than 1 per cent.
‘Earnings have recovered to historic highs,’ Rutledge comments. ‘If management had real confidence in expansion going forward, it would have rewarded shareholders by increasing the dividend.’
Nevertheless, buy-backs are seen as a means to raise stock prices, simply by reducing the shares outstanding. But this theory does not always translate into practice.
Certainly Chrysler’s stock is up some 17 per cent since it announced its buy-back program; but Dow Chemical’s is down 4.1 per cent. And a Bloomberg analysis of 1995’s ten biggest buy-backs reveals that the stocks involved did about as well as the S&P 500.
Richard Wines, managing director of Georgeson & Co, says the impact of buy-backs cannot be explained simply in terms of supply and demand. ‘Investment bankers sometimes assume that money is free,’ he suggests. ‘Companies that rely on loans for buy-backs, or use cash when it could earn more elsewhere, do not normally see valuation increase.’
Wines cites a classic study that tracked stocks from 1945 to 1970 and showed that market multiples declined on average after buy-backs. Georgeson’s own research into the buy-back boom following the 1987 stock market crash found that repurchases had no significant impact on valuations. ‘The strategy may prop stock price briefly, but it is not likely to provide lasting benefits after the repurchase program is over,’ Wines says.
Georgeson’s analysis did uncover another hidden benefit, however, which is that buy-backs lure growth investors, who tend to pay higher multiples than income investors.
From an IR perspective, Wines notes that buy-back announcements make waves and must be handled carefully. ‘Repurchasing shares may suggest a company doesn’t have anything better to do with the money,’ says Wines. ‘So it should be explained in the context of company strategy, underlining other ways cash is being spent to grow the business. If it’s done wrong, valuation could be hurt.’
To get a better understanding of the intricacies of individual buy-backs, Investor Relations looked at repurchasing programs undertaken by IBM, Citicorp, General Electric, Hershey and Standex International.
IBM’s buy-back results were tale-telling. Big Blue announced its buy-back in January 1995, following which its stock rose 31 per cent during the first half of 1995 to $96. That coincided with a strong rise in net income of $3 bn over the same period – in stark contrast with the $16 bn in losses run up during 1991-93.
Then in July IBM doubled its buy-back program to $5 bn, when the stock hit $107. At first the shares rose slightly, but then fell by 20 per cent over the second half in line with news of a $538 mn third-quarter loss.
The company added another $2.5 bn to its buy-back program at the end of November 1995, but the stock price dropped further amid a US-wide tech slide. It came back in January, rising to $107 by month’s end, which was just days after the announcement of better than expected fourth-quarter earnings of $2.03 bn.
The lesson? Buy-backs can work as advertised, but only against a backdrop of solid earnings growth.
‘I can walk into a room of portfolio managers and ask: What should IBM do with excess cash? But there are as many answers as there are investors,’ says Hervey Parke, director of IBM’s investor relations. ‘In the past, investors wanted huge restructuring and they got it. These days, some want dividends while others look for growth through acquisitions or buy-backs. Buy-backs usually show better long-term benefit.’
Parke’s IR approach is to outline IBM’s balanced spending strategy. Out of $13 bn excess cash generated in the last two years, close to $7 bn went to internal spending ‘just to grow the machine’. That included $2 bn for restructuring, and over $3 bn spent on external acquisitions like Lotus. Some $600 mn of leftover cash was spent on dividend payout, and core debt was reduced by some $1 bn. Finally, common stock buy-backs accounted for almost $5 bn and preferred stock repurchases for $1 bn.
Parke and CFO Rick Furman revisit the issue of cash management quarterly, explaining IBM’s plans to analysts and the media. Big Blue’s retail constituency is important so it maintains open relations with major brokers, too. Over the buy-back period, Parke says, earnings and debt ratings have improved. ‘There are different ways to return value to shareholders,’ adds Parke. ‘We are continually rethinking the balance.’
Some companies seem to do it all without endangering growth. Last year, Citicorp managed to restore its dividend, which it had withdrawn in 1991; and it announced $3 bn in buy-backs over two years starting in June. The plan came on the heels of a record $1.4 bn second quarter earnings. This year, the dividend was upped 50 per cent, and $1.5 bn was tacked onto the buy-back plan, now representing close to 20 per cent of the company’s shares.
The banking sector, which witnessed a plunge in share prices overall in 1994, is a big fan of buy-backs. Almost two-thirds of banks followed by Salomon Brothers analysts repurchased stock last year, including BankAmerica, Wells Fargo and First Bank System, each planning to buy back around 10 per cent of shares outstanding.
The strategy certainly seems to work for the banks, with the Dow Jones bank industry group up 55 per cent during 1995. According to Rick Roesch, senior vice president of IR at Citicorp, buy-backs are not a panacea for a sagging stock price but a natural extension of good performance for delivering value to stockholders. ‘A buy-back is good discipline for managing growth,’ says Roesch. ‘Its success should be measured by the long-term growth of the company, not by the stock price.’
Roesch explains that Citicorp sets target levels of return for different types of bank capital. Once targets are met, cash is earmarked for shareholders, either through dividends or buy-backs. The guidelines show ‘whether shareholders are better off with Citicorp investing the capital, or investing it themselves.’ At the same time, Roesch emphasizes that Citicorp is devoting cash to swift growth overseas.
‘A stock buy-back doesn’t push stock price up itself,’ says Roesch. ‘Nor should it come out of the blue. It should have strong earnings growth as a prelude. Then it has to be executed, and executed with discipline. Once analysts are confident the program will be carried out, they revise their earnings estimates. Over time, they may indeed change their recommendations. It’s an ongoing process.’
Few companies in the world can match General Electric for sheer financial muscle. So it should be no surprise that GE’s current stock buy-back program is one of the largest in the world, with some $14 bn in repurchases since 1990.
The company’s latest program, announced in December 1994 at $5 bn and upped to $9 bn in December 1995, helped boost GE stock 41 per cent over the year. This proved to be well above the S&P 500 average.
‘GE’s history is one of delivering value to shareholders,’ says investor relations manager Mark Begor. ‘We have focused on 20 years of dividend increases, growth through acquisitions and record levels of capital expenditures. Our low debt to capital ratio makes GE one of the few AAA-rated companies in the world. Combine those factors with high cash generation, and the logical outcome is a buy-back.’
Begor describes the acceleration of the buy-back program. GE paid out $1 bn a year to shareholders in dividends and buy-backs during the 1980s, and $3 bn a year from 1990 to 1994. From 1995 to 1997, the current plan is to spend $3 bn a year on dividends and $3 bn a year on buy-backs. ‘We are proactive in explaining what shareowners get in GE,’ says Begor. ‘We have top line growth, a record of cash generation on the bottom line, record capital expenditure, global niche acquisitions, yearly dividend increases, and buy-backs.’
On any given day, GE’s buy-back program represents 8-10 per cent of trading volume, which usually makes the company the largest purchaser of its shares. Begor says that the buy-back gives comfort to shareowners, provides price support, and improves earnings per share by 1-2 basis points. ‘Some companies make a big splash with a buy-back announcement, but don’t follow through,’ claims Begor. ‘GE is in the market every day, chugging away, buying back stock.’
Some companies discover the hard way that repurchasing stock while going into debt is unpopular with the Street.
Last year Hershey’s long-term bond rating was downgraded by Moody’s after a debt-financed stock buy-back of $500 mn from Hershey Trust. Moody’s cited concern over Hershey’s thirst for future repurchases. Hershey declines to comment, but notes that Standard & Poor’s reaffirmed its rating.
‘Buy-backs are a part of our comprehensive program to enhance shareholder value,’ says James Edris, Hershey’s director of investor relations. ‘We have a strong cash flow with adequate resources to reinvest in the business and make acquisitions. The leftover cash is used for buy-backs, which most analysts welcome.’ Under its buy-back program Hershey repurchased almost 4 mn shares in the open market during 1993-5.
Edris accepts that the impact of buy-backs on share price is hard to track, but says certain events undoubtedly move the market.
For Hershey the kicker came in August 1995 when it bought its 9 mn share block from Hershey Trust. ‘Trading was euphoric the next day,’ recounts Edris. Then in February this year the company traded up with the announcement of another $200 mn in buy-backs, at around the same time as a new low-fat chocolate was being unveiled. ‘That combination is tough to beat,’ says Edris.
Along the way, Hershey learned an important lesson. After the initial price surge following August’s buy-back, the stock price plummeted and Hershey could not fathom the reason why. It turned out that removing 10 per cent of its equity from the market in one day caused a re-weighting of Hershey stock in the S&P 500. So computer-driven index portfolios were furiously dumping stock and depressing the price. It only took a few days to balance out but, says Edris, ‘We should have been warned.’
Bluechips may dominate the buy-back arena in terms of dollars but small-caps still feature significantly. Of the 1,100 plans announced last year, 845 came from small companies. ‘I like to see buy-backs from small caps,’ says Nicholas Gallucio, vice president at Trust Company of the West and an investor in small-cap value stocks. ‘Many good little companies make lots of acquisitions but overpay. A buy-back shows they’re not squandering money.’
Gallucio offers various examples of small companies who have done a good job but gone unnoticed, so they do a buy-back. And he cites another, where mistakes were made. That sent the stock down and management, confident of long-term growth, took advantage of the low stock price to repurchase shares. ‘The typical investor in a buy-back-ready company is oriented towards value, not growth,’ Gallucio asserts. ‘The value investor looks for a mature company with excess cash flow and no place to put it.’
Standex International is one such small cap gem. The $420 mn Salem, New Hampshire diversified manufacturer has repurchased 57 per cent of its shares since 1985, while still increasing its dividend every year. ‘We wanted to provide value to our shareholders,’ says Edward Trainer, president and CEO of Standex. ‘With acquisitions becoming expensive, and cash mounting up, it made sense to invest in a business we knew the value of – our own.’
With a debt to capital ratio of 47 per cent, Trainer balances buy-backs with paying down debt. ‘Sometimes there’s a trade-off,’ he says. ‘Overall, Standex generates more return with buy-backs. The average price of all the stock we repurchased was around $15. Now it’s trading around $30. That’s a good investment, and our shareholders seem to think so too.’
Next month: European Buy-backs
