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Don't Buy the Buyback Hype

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Share repurchases supposedly rank right up there with dividends as a means of increasing shareholder value. But I've come to the opinion that they're little more than a tool for management to massage earnings, and I no longer see them as a positive sign for a stock.

Creating a quick boost in share price via a buyback can mask other problems. And if management really is so keen on the prospects of their company, shouldn't they keep the money in the company? As for the benefit to individual shareholders, it's not all it's cracked up to be.

The theory behind a share buyback is that a company is investing in itself. With oodles of cash on hand, there's supposedly no better place to put that money to work than buying back its own stock. ExxonMobil (NYSE: XOM  ) , for example, is so flush with cash from its oil profits that it has bought back more than $100 billion in shares since 2004.

Buybacks are seen as relatively benign maneuvers that reduce shares outstanding, thus distributing future profits to a smaller pool of owners. According to Standard & Poor's, companies in the S&P 500 spent $141 billion on share buybacks in 2007 -- more than twice as much as they earned in profits that year. Moreover, some studies suggest that companies that buy back their shares have outperformed the market by about 3 percentage points a year.

Short-term pops
Certainly the market loves a buyback. Anadarko Petroleum (NYSE: APC  ) announced a $5 billion buyback in August and shares jumped 8% in the days following the announcement. And Oracle (Nasdaq: ORCL  ) just signed on to buy back $8 billion of stock, joining Microsoft (Nasdaq: MSFT  ) , Hewlett-Packard (NYSE: HPQ  ) , and Nike (NYSE: NKE  ) .

While buybacks are considered a bullish signal that management is confident about the company's future, real confidence would have managers keeping the money in the company instead of "returning" it to the shareholders. Although some make the claim that buybacks are a more tax-efficient means of distributing capital to shareholders, the fact is that the shareholders that benefit most from a buyback are those who sell. Those shareholders that stay realize only the indirect benefit of owning an infinitesimally bigger piece of the overall pie.  

It's no surprise that many institutional shareholders like buybacks, as they tend not to be as worried about cash flow. They're looking to maximize value for their own shareholders, and in some cases, seeing the share price rise quickly gives them a chance to cash out at a profit.

Higher earnings at a price
The argument that a buyback boosts earnings per share is true, but it's an ephemeral manipulation that can be used to mask other problems. Reducing the number of shares outstanding when real earnings are falling can easily produce false increases in EPS. Too often, the repurchases only offset the dilutive effects of stock options.

Timing of buybacks also remains a key consideration, and, unfortunately, buybacks are made at prices that are too high. Sears Holdings (Nasdaq: SHLD  ) , for example, repurchased 13.4 million of its outstanding shares in the year that ended in August at a cost of $1.5 billion, or an average of around $112 each. The stock recently traded under $50 a stub.

The only real spending power a shareholder can earn is through dividends. In fact, the vast majority of gains from stocks over the past 130 years have come from reinvested dividends. In fact, analysts James Early and Andy Cross at Motley Fool Income Investor look for strong dividend payers regardless of market conditions, ones that return real profits to shareholders while providing capital returns over the long term.

With the markets tanking faster than companies can approve share repurchase programs, they're going to come under increasing pressure to prove that the buyback is more than just a means of propping up the stock or helping management make their bonus plan goals.

Of course, there are cases where a buyback is not a cheap magician's stunt. But for me, I'm going to presume them guilty as charged until they can prove their innocence.

Buy yourself some time with these related Foolish articles:

To see Income Investor's favorite stocks for new money now, click here. There's no obligation to subscribe. Sears Holdings and Microsoft are Motley Fool Inside Value picks.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (3)

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  • Report this Comment On October 28, 2008, at 11:08 PM, jhamoud wrote:

    I believe buybacks are still relevant and can still be a bullish indicator. While some arguable use them to massage earnings, the key to buybacks remains well timed and well priced. If a company is trading at a SERIOUS discuount to its intrinsic value and the potential return is higher than what management is currently capable of getting (i'm thinking ROIC), then why not.

    Wouldnt a share buyback for a company trading at a 50% discount to its IV / Share be a better use of capital than re-investing that money at a 25 - 30% ROIC?

  • Report this Comment On October 29, 2008, at 9:57 AM, cpa27 wrote:

    Whats the difference between reinvested dividends and buybacks? Nothing except with dividends I just paid a bunch of taxes. In both cases, you'll increase your ownership of the stock. If you think SHLD bought stock back at too high of prices, what would have been the benefit of getting a dividend back then and buying more stock at $112? Well, except the IRS would've sent me a bill.

  • Report this Comment On October 29, 2008, at 6:12 PM, madamebutterfly1 wrote:

    The merits of buybacks depend on a number of factors. Two have already been mentioned--One is when the stock is seriously undervalued vs its intrinsic value potentail -- I would add the caveat that in considering repurchases management has to ascertain that the marginal investment in buybacks is better than the next best capital investment opportunity the company has.

    Buyback also have the advantage that it allows the holder of stocks to tax optimize.

    In the case of an oil company like Exxon, they have shown that a well thought out strategy of buybacks has well worked for them.

    Their strategy is very simple. HIgh grade your investment portfolio, which mean only invest in high return project opportunities. These projects offer the tremendous advantage that they generate over time more cash than the cash the company needs to maintain a robust investment program. Thus the key question then become, with the excess cash, is it better to buy reserves from another company at a premium or to buyback the company's share to increase both earnings per share and barrels of reserve per share?

    The cost of reserve acquisitions from third party vs the cost of increasing reserves per share by buying your own shares is another parameter that Exxon looks at.

    A final point: By reducing the outstanding shares, Exxon saves the after tax cash flow required to pay dividends. Consider that since 2002 Exxon Mobil has bought back almost 4 billion shares. At todays yearly dividend of $1.60 one can calcualte that Exxon is saving on an after tax basis about $6.4 billion. Given Exxon's effective tax rate of close to 49%, Exxon is saving close to about $12 billion dollars per year of cash on a pre-tax basis that it does not have to generate--that is not chicken feed.

    In summary, if one looks at Exxon's history, Exxon has been very disciplined in its stock buyback strategy which it has used effectively over decades to put its tremendous cash flow to work at very low risk. If one looks at Exxon's performance over the past 20 years, one can see how effective buyback strategy has been. Others companies should look at Exxon on how to effectively use buybacks to increase shareholder's value.

    High dividend yields does not necessarily help -- just look at the performance of BP and Shell vs Exxon, which pays a much lower yield and I think you get the point.

    Madame Butterfly

  • Report this Comment On October 31, 2008, at 9:42 AM, XCgeoff wrote:

    I think stock buybacks in the energy sector right now are a great way to add value. If you look at Anadarko Petroleum, one of the companies mentioned in the article, their current stock price implies a valuation of approximately $10/bbl of reserves. Anadarko is funding the announced share buyback out of free cashflow, not by reducing capital spending or taking on additional debt. Anadarko probably couldn't purchase a company or other good assets for $10/bbl and I believe their finding and development costs, along with most of their peers (apache, devon, chesapeake) are > $10/bbl.

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