Friday, May 21, 1999
DJIA 10854.06 -12.68 (-0.12%) S&P 500 1333.88 -4.95 (-0.37%) Nasdaq 2527.02 -15.21 (-0.60%) Russell 2000 448.95 +0.93 (+0.21%) 30-Year Bond 92 1/8 +1/4 5.81 Yield

An Investment Opinion
by Matt Richey

Share Repurchase Rebates

When a profitable company generates excess cash flow, one of the best ways to return that cash to shareholders is through a share buyback. If a company knows its shares to be undervalued (and who else is in a better position to know?), then repurchasing shares is a surefire way for the company to create value by earning a higher return than its cost of capital. And even if a company thinks its shares are overvalued, a share buyback is almost always preferable to a cash dividend considering that dividends are taxed at the marginal tax rate, which can be 30% or higher. One last and not-often discussed advantage of share buybacks is that companies can generate cash from selling puts in conjunction with the repurchase.

We don't often discuss puts, calls, or any other options here in Fooldom, but using puts as a tool to lower the cost of repurchasing shares is very Foolish. First, let me explain how puts work. The language is a bit confusing, but I'll provide an example that should bring it all home.

Buying a put gives the holder the right, but not the obligation, to sell a stock at a certain price (called the "strike price") and before a certain date (the "exercise date"). Conversely, selling a put generates cash for the seller, but also obligates the seller to buy stock from the put holder if the option is exercised. Re-read that last sentence. It is the selling of puts that is creating loads of cash for companies like Microsoft (Nasdaq: MSFT) that regularly repurchase their shares.

For example, let's say that Microsoft, currently trading at ~$80, sells puts that obligate it to buy shares if they reach a strike price of $60 in the next twelve months. This transaction has several benefits. First and foremost, the put buyer pays up-front cash to Microsoft. Second, it allows Microsoft to repurchase shares on the dips. Very Foolish.

In fact, this example is exactly what Microsoft is doing, as explained on page 6 in the company's recently filed 10-Q:

"To enhance its stock repurchase program, Microsoft sells put warrants to independent third parties. These put warrants entitle the holders to sell shares of Microsoft common stock to the Company on certain dates at specified prices, and permit a net-share settlement at the Company's option. On March 31, 1999, 163 million warrants were outstanding. The outstanding put warrants have strike prices ranging from $59 to $65 per share and maturities ranging from 6 to 36 months."

These put transactions are like a big rebate on share repurchases. During the 9 months ended March 31 of this year, Microsoft had repurchased $1.5 billion of stock, but this cost was significantly offset by the $757 million in proceeds from put warrants. That's like getting a half-off sale! On net, Microsoft spent only $770 million to repurchase 25.6 million shares -- an average price of only $30 per share.

Intel, Dell, and other companies that regularly buy back shares also benefit from this devilishly profitable arrangement. Check out a company's cash flow statement (the financing portion) and the accompanying footnotes to uncover these juicy details.


Drug maker Schering-Plough (NYSE: SGP) bottled $3/4 to $49 1/2 on reports that Warner-Lambert (NYSE: WLA) is reportedly in merger talks with the company. No agreement is pending, according to Bloomberg. Schering-Plough is the eighth-largest U.S. drug maker, and Warner-Lambert is number nine. Analysts cited by Reuters dismissed the possibility of a merger between the two companies, saying, among other things, that Warner-Lambert's newly installed CEO is more likely to set out to grow the company himself than sell it now.

Biopharmaceutical company Immunex (Nasdaq: IMNX) won $1 3/8 to $134 1/2 after it issued a seven-year, 3% coupon, convertible subordinated note to its majority owner, American Home Products (NYSE: AHP), for $450 million. Immunex said the financing will "fuel our strategic plan and help Immunex capitalize on global opportunities for continued growth." The note is convertible into common stock of Immunex at a price of $173.68 per share, a 30.5% premium Immunex's closing price yesterday of $133 1/8.

Shares of cosmetics company Revlon (NYSE: REV) prettied up $1 1/2 to $30 3/4 on reports from The New York Times that the company is in preliminary talks to be acquired by Coty Inc. Coty, a subsidiary of Dutch consumer products company Benckiser NV, had revenues last year of $1.6 billion compared with Revlon's $2.2 billion. Revlon, which is controlled by billionaire financier Ron Perelman, has seen its shares rise 23% to $29 1/4 in the past week on merger speculation. For more on the news, head back to this morning's Breakfast With the Fool.

Shares of online health information services firms Healtheon (Nasdaq: HLTH) continued their rapid rise this morning, grabbing $6 3/8 to $107 on news of the company's plans to buy WebMD. Click here for a Foolish take on the deal from yesterday's Lunchtime News.

Music, video, and DVD distributor Valley Media Inc. (Nasdaq: VMIX) tuned in $1/4 to $28 after reporting fiscal Q4 EPS of $0.21, up from $0.13 a year ago. Q4 net sales rose 65.1% from $156.2 million to $257.9 million as online customers like Amazon.com (Nasdaq: AMZN) "contributed significantly."

Online marketing firm Modem Media.Poppe Tyson (Nasdaq: MMPT) popped up $3 to $27 1/4 after Business Week's "Inside Wall Street" column said "some pros... think Modem Media is on the way back to $45," which it hit on its Feb. 5 IPO day before returning to Earth, as global advertising dollars get pumped onto the Internet.

Telecommunications software firm Catapult Communications (Nasdaq: CATT), a February IPO, was flung up $11/16 to $25 11/16 after last night announcing its new CrossBow application, which allows users to create and test call processing simulations.

E-commerce go-between Priceline.com (Nasdaq: PCLN) was bid up $4 5/8 to $139 after Donaldson, Lufkin & Jenrette initiated coverage of the company with a "buy" rating and a $190 per share price target.

Steelmaker Armco Inc. (NYSE: AS) was burnished for a gain of $13/16 to $6 7/16 after AK Steel Holding Corp. (NYSE: AKS) agreed to buy the company in a stock swap currently valuing Armco at $7.50 per share, a 33% premium to yesterday's closing price.

Independent exploration and production company PennzEnergy Co. (NYSE: PZE), which yesterday agreed to be bought by Devon Energy Corp. (Amex: DVN) for $2.42 billion, was pumped up $13/16 to $15 5/16 this morning as Goldman, Sachs & Co. and Deutsche Bank Securities both upgraded the stock.

Auto parts maker Delphi Automotive Systems (NYSE: DPH) moved up $1 1/4 to $21 3/4. The company will be added to the S&P 500 Index, replacing Moore Corp. (NYSE: MCL) after the close of trading on May 27. General Motors (NYSE: GM) is spinning off its remaining 80.1% stake in Delphi to GM shareholders. Moore Corp., which is being removed for lack of representation, lost $1 1/4 to $8 7/16 this morning.

Managed care provider Trigon Healthcare (NYSE: TGH), which last night announced the authorization of the buyback of up to 10% of its common shares, rose $3/16 to $36 3/8. The company said it may buy the stock on the open market by block purchase or in private transactions.

Hanger Orthopedic Group (NYSE: HGR), an orthotics and prosthetics services company, moved ahead $7/8 to $18 1/16. The stock will replace CompDent Corp. (Nasdaq: CPDN) in the S&P SmallCap 600 Index after the close of trading today. CompDent is being acquired by private investment firm TAGTCR Acquisition Inc.


Equipment rental firm NationsRent (NYSE: NRI) shed $1/2 to $5 9/16 after announcing that it ended its merger agreement with Rental Service Corp. (NYSE: RSV) because the terms of the previously disclosed agreement "restricted our ability to continue the growth of our business through acquisitions and internal expansion." NationsRent will take an unspecified pre-tax charge in the second quarter related to the failed merger, which will be partially offset by a $6 million payment from Rental Service, shares of which advanced $1 9/16 to $23 7/8.

Italian footwear maker Fila Holdings (NYSE: FLH) slipped $1 9/16 to $14. The company launched an interactive shopping website today. The store, according to executives, is meant more as a marketing vehicle than a major revenue source; a portion of the "net" sales will be given to charity.

Metal products manufacturer Amcast Industrial Corp. (NYSE: AIZ) rusted $1 5/16 to $16 7/16 after it said it doesn't expect to meet Wall Street's analyst estimates for fiscal Q3 -- IBES' three-analyst consensus estimate is $0.65 -- because of higher-than-expected production costs at its North American plants driven by a tight labor market and employee turnover. Technical problems at a new plant in Ohio also factored in.

Banana, pineapple, and melon grower Fresh Del Monte Produce (NYSE: FDP) softened $1 to $13 1/2 after it said it expects Q2 EPS of between $0.55 and $0.75 per share, missing IBES' $0.83 estimate. The company lowered its estimate because of depressed banana pricing in Europe.

Online health and medical information provider adam.com (Nasdaq: ADAM) lost $3 9/16 to $23 3/16 this morning. Late in yesterday's session, the company issued a press release in response to the pending merger between Healtheon and WebMD in which CEO Robert Cramer Jr. said, "we have no intention of abdicating our goal of becoming the number one consumer health destination Web site. Mega-mergers make great headlines, but they do not establish market share dominance of consumer audiences."

Southwest Airlines' (NYSE: LUV), which approved a 3-for-2 stock split at its annual meeting yesterday, descended $1 13/16 to $29 15/16 this morning. Shareholders didn't vote on a proposal to have Chairman, CEO and President Herb Kelleher choose between either running day-to-day operations or chairing the board because the shareholder who proposed it didn't make it to the meeting. The shareholder was concerned with the healthiness of Kelleher's lifestyle.

Atlantic Coast Airlines Holdings (Nasdaq: ACAI), which operates United Express, descended $6 1/16 to $16 15/16 after Hambrecht & Quist downgraded the stock to "buy" from "strong buy."

Chairmaker La-Z-Boy (NYSE: LZB), which last night reported fiscal Q4 EPS of $0.43, $0.03 better than IBES' six-analyst consensus estimate and $0.06 ahead of last year, nevertheless lost $9/16 to $20 5/16 this morning.


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