The Dark Side of Stock Buybacks

Today's topic is free cash flow (FCF) -- that is, the cash left over after a company pays all cash expenses and makes necessary investments in capital equipment and working capital. Some companies use FCF to offset dilution from option exercises (they'll use the cash to repurchase shares). Today, we'll explore a truer FCF picture in those cases.

A little background
An excellent use for FCF may be share buybacks, which create value if shares are demonstrably undervalued (a task in itself). But throughout the late 1990s and into the new century, a lot of companies lost sight of this proper rationale for share repurchases. Instead, buybacks became de facto dilution-control schemes, as management bought back shares in amounts roughly equal to shares being issued for employee stock options. Notable practitioners of this art include homebuilder NVR (AMEX: NVR  ) ; Dell (Nasdaq: DELL  ) , whose trailing-10-year profit ($19.5 billion) translated to minimally increased ($3.1 billion) shareholders' equity; and Microsoft (Nasdaq: MSFT  ) , which even admitted what it was doing in its 2003 10-K:

We repurchase our common shares primarily to manage the dilutive effects of our stock option and stock purchase plans, and other issuances of common shares.

Here's how that looked for Microsoft.

Period

FY 01

FY 02

FY 03

Three-Year Total

Options Exercised (millions)

246

198

234

678

Shares Repurchased (millions)

178

256

238

672

Average Exercise Price

$5.57

$6.41

$6.89

$6.27

Average Repurchase Price

$34.12

$23.71

$27.18

$27.69

Total Spent on Repurchases ($ millions)

$6,074

$6,069

$6,468

$18,611

Total Cash Inflow From Option Exercise ($ millions)

$1,370

$1,269

$1,612

$4,252

Option Income Tax Benefits ($ millions)

$2,066

$1,596

$1,376

$5,038

Companies that bought their own shares for reasons that were arguably beneficial to shareholders include automotive safety system supplier Autoliv (NYSE: ALV  ) . The company has returned nearly every penny of FCF to investors through buybacks and rising dividends over the past five years, all while using options very sparingly. Small-cap bad-debt buyer Asset Acceptance (Nasdaq: AACC  ) -- although going through a rough patch -- is also looking to repurchase nearly 7% of the company, while employing few options.

Unfettered is better
Fools are generally pretty good at teasing out a company's FCF. But FCF is, by definition, the cash theoretically available to the owners (shareholders) after all the continuing needs of the business have been taken care of. In the Microsoft case above -- even after accounting for cash inflows from options exercised (cash from the option holder plus the tax benefits) -- to "hold the line" on dilution, Microsoft's owners (shareholders) paid out a net $9.3 billion. Enter the concept of "Unfettered FCF."

Albert Meyer of Bastiat Capital has expounded on unfettered FCF. A former accounting professor, Meyer argues that companies offsetting option dilution with stock repurchases are effectively engaging in "deferred compensation expense." As such, investors should recast the cash flow statement by moving the components of option exercise and repurchase from the section for Cash Flows From Financing Activities (CFFF) back up to Cash Flows From Operations (CFFO). In Creative Cash Flow Reporting (featuring a dust-jacket testimonial from our own Bill Mann), Mulford and Comiskey argue for much the same treatment.

A example close to home
Among the Motley Fool Hidden Gems lineup of picks, which one may be said to be buying back shares for anti-dilution purposes rather than because those shares are a screaming bargain? Blue Nile (Nasdaq: NILE  ) immediately springs to mind. I've questioned Blue Nile's practice of touting the simple definition of free cash flow (CFFO less capital expenditures) in its press releases, as a fair amount of its CFFO has, historically, been attributable to the releasing of deferred tax assets created by past operating losses (a practice nearing its end, as the company is now profitable).

Let's look at Blue Nile in a light similar to our Microsoft analysis above.

12 Months Ended July 2, 2006

2005

2004

Total Since IPO*

Options Exercised (thousands)

389

167

128

568

Shares Repurchased (millions)

1759

565

0

2021

Average Exercise Price

$3.76

$3.44

$1.13

$3.08

Average Repurchase Price

$32.03

$30.75

0

$31.54

Total Spent on Repurchases ($ millions)

$56.3

$17.4

0

$63.7

Total Cash Inflow From Option Exercise ($ millions)

$1.5

$0.6

$0.1

$1.7

Option Income Tax Benefits ($ millions)

$1.3

$1.2

$0.3

$2.1

*Blue Nile IPO'd in the second quarter of 2004. This is the total of the nine reported public quarters from Q2 04 through Q2 06.

Blue Nile has purchased significantly more shares than it has had options exercised. Considering only the offsetting repurchases to dilution, my estimates of FCF take a fairly substantial hit (Hidden Gems subscribers can see further details of the unfettered FCF calculations on our Blue Nile discussion board).

$ millions

12 Months Ended July 2, 2006

2005

2004

Total Since IPO*

FCF**

$24.3

$26.5

$18.3

$39.6

FCF Offset by Net Option Exercise/Repurchase

$10.0

$3.0

($0.4)

$13.6

Unfettered FCF

$14.3

$23.5

$18.7

$25.9

*See note for previous table.
**I use what I call the NOPAT model (Net Operating Profit After Tax) to calculate FCF. I believe this model offers a better picture of the cash-generating ability of Blue Nile, because the company's tremendous negative working capital model is built in.


Arguably, the most important number in the table above is in the right-most column, where we see that option dilution and subsequent repurchase has claimed roughly a third of the total free cash that Blue Nile has produced since its IPO. At a recent closing price of $34.47, Blue Nile would seem to be trading at an enterprise value-to-FCF ratio of 21.5. But considering unfettered FCF as the denominator, that ratio rises to 36.5, which suggests the "true" price investors are paying for Blue Nile today (if we're counting only the FCF benefiting outside investors).

Blue Nile has 1.3 million options outstanding, with exercise prices below $22. This includes 0.5 million options with an average exercise price of $0.26. Going forward, expect these options to offset the extra shares Blue Nile has purchased in recent months. Watching the unfettered free cash flow will keep investors informed as to what portion is actually theirs.

This article was adapted from the Aug. 22, 2006, Hidden Gems Daily column. For free, full, and unfettered access to every aspect of our small-capMotley Fool Hidden Gemsinvesting service -- including stock recommendations, research, daily updates, and discussion boards -- click here. Our picks are beating the market by more than 17 percentage points since we started. Take a trial today, and you'll have access to the two brand-new small-cap stock picks, which release at 12 noon ET.

Fool contributor Jim Gilliesowns shares of Autoliv. Dell and Microsoft are Inside Value recommendations. Blue Nile is a Hidden Gems and Rule Breakers recommendation. The Fool has a disclosure policy.


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