Ever since interest rates fell near zero during the financial crisis, many companies have become addicted to debt-funded buybacks. One such company is mobile chipmaker Qualcomm (NASDAQ:QCOM), which introduced a $15 billion buyback plan in March to repurchase $10 billion in shares over the following 12 months. In May, it launched an accelerated plan to repurchase $5 billion due to pressure from activist investor Jana Partners. To fund those big buybacks, Qualcomm took on $10 billion in debt.
Qualcomm has bought back $10.5 billion in shares over the past 12 months. During that period, it only paid out $2.9 billion in dividends from a free cash flow of $4.5 billion. Let's take a closer look at these buybacks and discuss why they're potentially toxic for investors.
Catching its own falling knife
Companies generally initiate buybacks when they think that their shares are undervalued and have upside potential. But when Qualcomm started its buyback spree earlier this year, the company was facing huge headwinds.
Samsung (NASDAQOTH:SSNLF), one of its biggest customers, installed its own Exynos processor instead of Qualcomm's Snapdragon 810 in its flagship devices, causing the company to reduce its full-year sales guidance several times throughout the year. A $975 million antitrust fine in China was weighing down its bottom line, and various reports claimed that Intel's (NASDAQ:INTC) wireless modems could replace Qualcomm's in certain iPhones. Faced with these problems, Qualcomm probably knew that its stock was headed lower, but it kept buying back shares as the stock tumbled nearly 25% over the past 12 months.
Investors lose, executives win
In addition to a plunging stock price, Qualcomm fell behind the tech curve when Apple (NASDAQ:AAPL) launched its first 64-bit mobile chip in 2013. Qualcomm's first 64-bit mobile chip, the Snapdragon 810, arrived a year later and suffered from overheating issues -- which likely spooked Samsung. Qualcomm also hasn't fully resolved its wireless licensing issues in China, where OEMs are underreporting shipments to pay the company lower royalties.
These missteps all suggest that the management deserves a pay cut, but that's not happening. Qualcomm CEO Steven Mollenkopf was actually the eighth highest paid CEO among the top 200 U.S. companies last year with a salary of $60.7 million ($58 million in stock). Neither Apple's Tim Cook or Intel's Brian Krzanich made the top ten.
But it's not just Qualcomm's CEO who gets a big pay package. Back in 2010, Qualcomm paid out $47.7 million in executive compensation. Last year, that figure skyrocketed to $186.5 million. Since most of its executive compensation is paid in stock bonuses, Qualcomm is actually using buybacks to offset the dilution. In fiscal 2015, Qualcomm spent $1.03 billion, or 4% of its revenues, on stock-based compensation. This means that roughly 10% of Qualcomm's buybacks over the past year were used to offset dilution from employee bonuses.
Better uses for $10 billion
Qualcomm could possibly address its problems with Apple, Intel, Samsung, and cheaper mobile chipmakers by spending more on R&D. However, Qualcomm's R&D expenses stayed nearly flat year-over-year in fiscal 2015 at $5.49 billion, or 22% of its revenues. Intel also spent 22% of its revenues on R&D in the first nine months of the year.
But if Qualcomm is serious about challenging Intel in drones, wearables, and Internet of Things devices to expand beyond the saturated market for mobile chips, it should raise R&D expenses instead of buybacks. It could also buy plenty of other smaller chipmakers with $10 billion.
Qualcomm could also spend more on dividends than buybacks. Qualcomm already pays a decent forward annual yield of 3.4%, but that percentage was inflated by the stock's abysmal performance over the past year. If Qualcomm boosts that yield just a little more, it could attract more income investors and set a more stable floor under its stock price.
Buybacks aren't always bad
Stock buybacks are effective when they're used responsibly. Companies that buy back shares when they're undervalued reap big rewards when their stocks recover. Valuations also tend to tighten up as earnings per share improve.
But Qualcomm isn't one of those companies. Its buyback plan seems designed to pay employees and artificially inflate earnings at the expense of its shareholders. The money spent on buybacks should have been spent on R&D, acquisitions, or dividends -- which would have all added more long-term value to the stock.
Leo Sun owns shares of Qualcomm. The Motley Fool owns shares of and recommends Apple and Qualcomm. The Motley Fool recommends Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.