When Buybacks Go Bad

Monday was another in a long string of bad days for bankrupt Delta Air Lines (Pink Sheets: DALRQ). That's when Chief Financial Officer Edward Bastian appeared before federal judge Prudence Carter Beatty and argued his case for making $3 billion in annual cost cuts, which would include voiding the airline's contract with pilots and imposing $325 million in wage cuts.

If that sounds Draconian, Beatty probably agrees with you. The Associated Press reports that she found it somewhat remarkable that Delta spent billions buying back its own shares from 1996 to 2000. And she didn't mince words, saying that if Delta "had that money rather than had spent it that way, you might not be in the position you are in."

In other words: If Delta hadn't repurchased shares, it might not be squeezing its employees today.

I sympathize with the sentiment. Airlines, after all, have proved to be an awful business, and mismanagement has played a role in the wanton destruction of shareholder value. But is that really what happened here? It seems so on the surface. Consider this filing with the Securities and Exchange Commission, which says that Delta's board authorized the company to "repurchase up to 49.4 million shares of common stock issued under our broad-based employee stock option plans." Then it refers to note 14 in the same document. Read that, and you'll find that the company planned to -- wait for it -- issue as many as 49.4 million options. That means the buybacks were probably aimed at offsetting expected options dilution, a practice we've frowned on here many times for its propensity to transfer wealth from owners to employees. But there's more to this story. Have a look at the chart below (at the end of this article).

See the pattern here? Delta may have planned on burying its options dilution, but that's not what happened. Instead, more than 20 million shares, net of option exercises, were taken off the market -- which shows that management was probably trying to do the right thing. If only that mattered. The buybacks, you see, did absolutely nothing for earnings per share. Instead, dilution persisted. A check of the 1996 and 2001 10-Ks shows that average shares outstanding rose from 103.1 million in 1996 (double the 52 million listed in the 10-K to account for the 1998 split) to 123.8 at the end of 2000, or 19%. What happened, you ask? Delta issued more than 17 million shares from convertibles notes and preferred stock in 1996 and another 11 million in 1997. Ouch.

It gets worse. By the end of 1999, there were signs aplenty that Delta's business was fundamentally deteriorating. For one, operating margin declined by a breathtaking 3.7% from the year prior. But when sales recovered mightily in 2000, rising more than 12% year over year, margin recovered by less than a point. Delta, it seems, was booking more and getting less, all while spending more than $1 billion on share purchases. So when the airline posted a net loss of more than $1.2 billion for 2001, it began a downward spiral from which it has yet to recover. And that, sadly, probably makes Judge Beatty mostly right in her criticisms. What a surprise.

Year

Shares Repurchased

Cash Spent

Average Buyback Price

Options Exercised

Net Change in Share Count

1996

821,300

$66 million

$80.00 per share

1,654,000

+832,700

1997

5,378,700

$379 million

$70.53 per share

1,279,000

-4,099,700

1998

3,158,373

$354 million

$112.08 per share

4,659,000

+1,500,627

1999

10,971,166

$625 million

$56.96 per share*

2,410,000

-8,561,166

2000

10,626,104

$502 million

$47.26 per share*

725,000

-9,901,104

Total

30,955,643

$1.926 billion

$62.22 per share

10,727,000

-20,228,643

*Delta's shares split 2-for-1 on Nov. 17, 1998.

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Fool contributor Tim Beyers wonders whether Delta will be the first of the major airlines to liquidate. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile. The Motley Fool has an ironclad disclosure policy.


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