Last week, I introduced a concept called the share buyback yield in an effort to quantify the value of share repurchases relative to dividends. This week, I'd like to present a scenario in which share buybacks don't add real value to shareholders. Our real-world case study will be none other than Dell Computer
Dell is a truly amazing company, and any student of business cannot help but marvel at what it has accomplished over the past decade or so. The company has grown revenues and earnings some 40-fold since 1992, and was one of the best-performing stocks of the 1990s. Even through the tech wreck of the past three years, it managed to grow revenue by $10 billion and increase net income by almost a third.
Unfortunately, it doesn't create anywhere near the value for its shareholders, on a per-share basis, as it could and should.
Dell's problems are twofold. The first is that the company's employee stock option grants and option purchase plans have been so generous that most of the value created by its business gets redistributed from shareholders to employees. The second problem has been its policy of repurchasing shares at high prices to combat share dilution.
The numbers tell the story
Let's bring out the hard evidence from the financial statements. As the table below shows, over the last five fiscal years, Dell has generated about $16 billion in free cash flow. The company has also used $10.5 billion to repurchase shares, and has received about $1.5 billion in cash from issuing stock to employees via options exercises and through an employee stock purchase plan.
DELL'S CASH FLOW 1998-2003($ in millions)Year OCF Capex FCF Bought Issued Back
2003 3,538 305 3,233 2,290 265 2002 3,797 303 3,494 3,000 2982001 4,195 482 3,713 2,700 3952000 3,926 401 3,525 1,061 2891999 2,436 296 2,140 1,518 212Total 17,892 1,787 16,105 10,569 1,459
Considering that Dell spent $10.5 billion to repurchase shares, you'd think that it would have reduced its share count rather dramatically, right? Wrong. Take a look at the number of shares outstanding from the annual 10-K reports for each of the past six years:Date Shares Outstanding03/31/1998 2,561,267,616 03/31/1999 2,536,184,711 03/24/2000 2,586,748,307 04/24/2001 2,611,286,980 04/15/2002 2,595,716,115 04/21/2003 2,568,285,953
Amazing, isn't it? Despite spending over $10.5 billion to repurchase shares, Dell's total shares outstanding actually increased by a fraction.
How is this possible? Walking through the numbers for one year gives you an idea. Taking just the fiscal year ending January 2003, the company issued 22 million new shares via employee stock option exercises at an average $7.69 per share, receiving $169 million. It also issued 4 million shares under the employee stock purchase plan. I calculate that it issued those 4 million shares for $96 million, or an average price of $24. According to the 10-K, Dell spent $2.29 billion and repurchased 50 million shares in fiscal 2003, an average price of just under $46 per share.
To recap, Dell issued 26 million new shares for a total of $265 million, or just over $10 per share, and bought back 50 million shares at $46 per share. The difference in price on just the 26 million shares issued is about $936 million. (By the way, if you are wondering how the company managed to pay $46 per share during fiscal 2003 when the stock price never got above $30, it's because it sold put options at the higher price a few years ago.)
One good reason
See, here's the thing about share buybacks -- they only work when shares are repurchased at prices that are well below what the business is worth. Clearly, Dell's bigger sin by far is an over-generous issuance of stock options to employees. But buying back stock at inflated prices doesn't help any. Let me quote a passage from Warren Buffett, who wrote this about share buybacks in the 1999 Berkshire Hathaway annual report:
Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around. Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This "buy high, sell low" strategy is one many unfortunate investors have employed -- but never intentionally!
Buffett later goes on to note that "there is only one combination of facts that makes it advisable for a company to repurchase its shares: first, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated."
The final tally
So if all those repurchased shares didn't add anything to per-share intrinsic value, just how much value did Dell create over the past five years? Since it doesn't pay dividends, and two-thirds of its free cash flow goes to repurchase shares, the only tangible sign of shareholder wealth creation is on the balance sheet, which is where the leftover cash goes.
Dell's net cash position has increased from $1.8 billion in 1998 to $9.4 billion today. That $7.6 billion difference represents the sum total of shareholder wealth that it has retained over the past five years -- about $1.5 billion per year. That's still a lot of cash, but if you pay today's market value of $82 billion, it would take 55 years to get your investment back if the company were to create value at the same rate going forward.
Zeke Ashton has been a longtime contributor to The Motley Fool, and is the managing partner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. Zeke will only buy Dell computers, but does not own shares of Dell stock. Please send your feedback to [email protected]. The Motley Fool has a disclosure policy.
