First off, I'm begging Amgen's (Nasdaq: AMGN) management for forgiveness, though they don't know why. Until late yesterday, this column was going to call them all lowdown varmints of the worst order and declare my trust in them forever broken. I even blasted an e-mail to the other portfolio mangers, David Gardner and Jeff Fischer, sneering that this should really be our sell report for Amgen.
Ah, but then it occurred to me, maybe I didn't know everything. A remote possibility (kidding!), but still enough to make me consult our most excellent corporate development dude and financial whiz, Gary Hill (TMF Chill). Gary showed me the blazing, bright, and blinding light.
My complaint concerned management's decision last week to use 25% of a $2.5 billion debt offering -- a cool $650 million -- to buy back stock. Issue debt to buy back shares? That represented the worst kind of short-term bolster-the-stock-price mentality, was at odds with shareholders interests, and demanded that top execs face the firing squad. Mix in my conviction that the company overpaid for its proposed purchase of Immunex (Nasdaq: IMNX), and there would be no mercy.
I was wrong.
Why buy back shares?
When good management decides to spend shareholder money for a share buyback, it believes that those shares will appreciate over a given period at a better rate than any other investment of those dollars, such as granting taxable dividends to shareholders or investing that cash in drug research and development, another company, Treasury bills, or even recommendations for our discussion board posts, which were recently selling on eBay (Nasdaq: EBAY). If the shares do appreciate later, the company can capture that return by issuing new shares. For a more detailed explanation of the best management's decision making process for share buybacks, Fool alumnus Dale Wettlauffer tells us why this cost-benefit analysis really matters (click the link, and then scroll down).
So it's not important whether cash or debt funds the buyback, it's one thing only: Will using the money to buy back shares create more value than any other use of the money?
Because I believe that the stock is overvalued relative to its growth prospects for the next five years, I answered "No way!" I failed to see the big picture.
Here's the basis for saying that Amgen's stock is overvalued:
As of Dil'd % +/- % +/- EV/
12/31 EPS EPS P/E FCF FCF FCF
1997 $0.693 -- 20 $551 mil. -- 27
1998 0.801 16% 33 742 44% 36
1999 0.985 23% 61 923 24% 69
2000 1.038 5% 62 1199 30% 56
2001 1.157 11% 49 806 ttm -33% 73
Sooner or later, Amgen's astronomical P/E will come closer to EPS growth, and its EV/FCF will fall closer to its FCF growth. When that happens, look out below! (You can join others in the Fool community and learn to screen stocks for these numbers and situations in our upcoming Panning for Gold online seminar!)
True, that drop may not matter to investors who hold the stock expecting value creation for beyond five years, but it may be important if you have a better place for your money today, after deducting capital gains taxes from your sale proceeds. It may also matter to bad management, obsessed with the stock price in the short term and perhaps subject to wrong compensation incentives from the company's board.
Should execs do anything about the stock price?
Good management says, "Over periods of five years or more, on average, stock prices follow the value of the business. In shorter periods, it's noise. So the best way to keep our stock price rising over the long term is to invest in the business and create value. We can use our high stock price to raise investment cash by issuing more shares and/or through purchasing complementary businesses with stock and cash. We did that through our Immunex purchase.
"We agree with that usually clueless Motley Fool guy that because of our business success, our stock is already priced for our growth over the next five years or so. But guess what? That gives us another option. We can find investors who disagree with that assessment who will lend us money at absurd rates for an option on our future stock price. Then we can invest that money to produce more future value."
We became part owners of Amgen because we believed that management will create value. Also because we think its red and white blood cell stimulating products are cool and we get to say things like, "We're talkin' bloooooooooddd, baby, bloooooooooddddddd," which is why Foolish writers and readers have more fun than any others.
"Zero coupon," say what?
So Amgen found a buyer for $2.5 billion in 30-year zero-coupon notes. "Zero coupon" means that the issuer makes no interest payments until maturity. The buyer earns interest another way. In Amgen's case, the buyer pays a discounted $715 but is repaid $1000 at maturity. The difference of $285 represents a yield-to-maturity of 1.125% compounded annually. (If interest were paid every six months instead of annually, the discount would be greater.) This is cheap, cheap, cheap.
Cheap compared to what? To what you might think is Amgen's cost of capital otherwise. First off, these are not really 30-year notes. The notes allow Amgen to redeem them after five years. The note holder can convert them to shares at $80.70 at any time, and can demand that Amgen redeem them for their accreted value ($715 per $1000 plus 1.125% per year) at 3, 5, 10, or 15 years, but Amgen can choose to pay in cash or stock. The rate is way low compared to the 2 and 5-year Treasury bill rates of 2.98% and 4.20%, respectively (there is no three-year bill), and also trumps with ease the two-year double A-rated corporate debt rates of 3.36% and five-year Triple AAA rate of 4.46%.
Amgen management sez, "The note buyer thinks our future stock price will be higher than we do in five years or fewer. If we are right and it's not, we get $2.5 billion to invest now for the almost-free cost of 1.125% a year. If we are wrong, and our stock price exceeds $80.70 anytime, note holders can convert and we effectively pay more for the money -- the difference between our current stock price and the future price, figured at an annual rate. But because we think we can invest the money now for a better return, we'll take that risk."
The note holders hope that Amgen is wrong. If the stock price exceeds $80.70, note holders will exercise their conversion right at their three- or five-year option. That means that Amgen in effect ends up paying a higher interest rate (and it can pay in either stock or cash) for the use of the $2.5 billion for that period. For three years, that's 1.125% per year plus the difference between $80.70 and $58.97, or a hefty 12.15% per year. For five years, it's 7.5% a year. But this is Amgen's effective interest rate, not what the note holder gets.
The note holder's reward comes the more the stock price beats $80.70. If it exceeds that conversion price by 20% in three or five years, it effectively earns 1.125% annually plus 6.324% a year (three years) or 4.87% (five years). The higher the stock goes over $80.70, the higher the effective interest rate. We already saw that these rates are higher than Treasury bills or highly rated corporate debt for the same periods. That's the appeal for note buyers.
And that pesky stock buyback?
Amgen management has had a pretty good record of spending money to create value, so I'll grant management the benefit of the doubt that some of the following is true: The $650 million buyback might have been a condition of the note buyer to improve its risk-reward ratio, and management can deploy the remaining $1.85 billion to produce enough return to compensate and to balance the risk that a rising stock price might retroactively raise the cost of the notes.
If I'm wrong, management made a bad decision, but not nearly as bad as I first thought. You can bet we'll be watching to see if they allocate the capital well and deserve this trust.
Why keep an anemic stock?
Wait, you say, if the company bets the stock will be under $80.70 for the next five years, isn't that an anemic return from yesterday's $58.97 close? Why are we holding it? That's a subject for ongoing debate.
Should we sell Rule Breaker businesses like Amgen and AOL Time Warner (NYSE: AOL) that have rewarded us but are now settling into slower or no growth for a while? Or should we retain these good businesses that might be called Rule Breaker graduates (get your diploma here), that offer good returns but over long timeframes of at least five, but preferably 10 or more years? Join the discussion on the Rule Breaker -- Strategies discussion board or chime in on this Amgen board thread (30-day free trial to view, subscription required to post)!
Stay Foolish, because it's dangerous out there!
Tom Jacobs (TMF Tom9) can't live without clutter. At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's dandy disclosure policy.