Buybacks That Are Better Than Dividends

Companies basically have three choices for the use of their cash. They can hold onto it to reinvest in the business, return it to investors in the form of dividends, or repurchase shares. The last option increases the fractional ownership that each share represents.

Within the drug company sector, share buybacks make varying degrees of sense.

Good
Companies aren't necessarily the best market timers. In fact, some data would suggest they're downright bad at it, so it's arguably better to issue dividends and let investors decide which stocks they might want to invest in when the cash is available.

But pharmaceutical companies are in an interesting predicament at the moment, with many guiding for drops in earning as their drugs go off patent. Pfizer's (NYSE: PFE) Lipitor, Bristol-Myers Squibb's (NYSE: BMY) Plavix, and a suite of drugs from Eli Lilly (NYSE: LLY) will be especially troublesome.

By using extra cash for a buyback rather than increasing the dividend payment now, companies get more flexibility for the leaner times. The only thing investors hate worse than no dividend at all is a dividend that gets cut. Buybacks end up being the default choice for pharma giants if they don't need the cash but don't want to tempt fate with a higher dividend.

Better
The place in health care where I think buybacks make most sense is for large biotech companies. Amgen (Nasdaq: AMGN) paid its first dividend this month -- a token 2% -- but it's still using cash to repurchase shares. Similarly, Biogen Idec and Gilead Sciences, have repurchased a lot of shares in recent years.

Source: Capital IQ, a division of Standard & Poor's.

Celgene is the lone wolf of the big four, but it's been spending its cash on the business. Research and development expenses tripled since 2007.

Like the pharma companies above, it's all about flexibility. Establishing a dividend pins the company into offering it every year if it wants to keep long-term investors happy. Flexibility to use the cash to repurchase shares one quarter and use the cash to license a drug or buy a development-stage company the next is paramount to a successful future for most biotech companies.

Weird
Some smaller biotechs have also established share repurchase programs, which seems like an odd use of cash. Spectrum Pharmaceuticals (Nasdaq: SPPI), for instance, recently initiated a stock repurchase program that could see it buying $25 million worth of its shares -- about 6% of its market cap -- through the end of 2012. The repurchases will offset stock issued through warrants and employee options, so this is more of an avoiding-dilution move than an increasing-equity situation for investors.

I'm all for avoiding dilution -- it's a killer even for biotechs that make it to the finish line -- but Spectrum can't find anything that would grow its bottom line faster than repurchasing shares? The company is rumored to be bidding Allos Therapeutics (Nasdaq: ALTH), so perhaps the answer to that question is actually yes.

Again, flexibility is the key because even though the board has authorized the repurchase, the company doesn't have to buy the shares.

The final Foolish word
I don't think investors should make a decision based solely on whether there's a dividend or a buyback in place, but they should be aware of what management is doing with their cash. Ultimately, I think share repurchases make a lot of sense for many drugmakers because of their flexibility, if nothing else.

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