Archive for February, 2012

Follow the Capital: The Real Impact to Shareholders

February 1st, 2012

  • Decapitalization Impairs Prospective Growth
  • Is IBM Vulnerable?

(full tables and charts available to CT Capital clients only)

Let me begin by clearing up a common misperception perpetuated by CFO’s during company conference calls:  share buybacks do not reward shareholders, only higher valuations and dividends do that. And because they do zilch to improve ROIC, they routinely force multiple contraction despite improved GAAP metrics, such as return on equity and per share metrics, including earnings and book value.

The logic is irrefutable: long-term shareholder value takes place through increases in free cash flows, with risk remaining at appropriate levels. This occurs via proper investments in assets, projects, and research, the polar opposite of what many firms are doing today in an appeasement to institutional shareholders.

Share repurchases are often construed as acquisitions identical to the assets of the firm.  This line of thought is incorrect for several reasons, not the least of which is the negative repercussion to cost of capital.

It can be easily proven that if an entity was able to purchase another firm having identical free cash flows, cost of capital, and normalized safe positive spread among the two, presuming its post-acquisition cost of capital remains unchanged, it should purchase the outside asset rather than its own stock, for by expanding its capital base, its prospective free cash flows, return on invested capital and economic profit would also grow, thus enhancing shareholder wealth. Likewise, if the free cash flows were used to reduce cost of capital, fair value would be enhanced. This is true almost regardless of the free cash flow yield of the acquired entity.

Berkshire Hathaway, during the period it was disengaged from share repurchases as it was expanding its capital base, saw its shares widely outperform the general equity markets, while, after announcing it was prepared to inwardly direct its free cash flows, has seen its stock underperform.

If a material[1] level of resources results in value-adding activities, shareholder value is enhanced. If invested capital or other opportunities were limited due to de-capitalization measures, investors will ultimately pay the price, as free cash flow growth is unstable and unpredictable for many periods along the business cycle; firms which engage in share buybacks with cash on hand also find their cost of capital ( and share price volatility) rise for the same reason.

If leverage is required to aid share buybacks, cost of capital rises and financial flexibility declines even more so. This may occur for reasons other than the attrition of the cash cushion, including workforce reductions, credit rating downgrade, incapacity to hold onto market share, instability of financial metrics and reduction in interest charge cover.

In furtherance of my argument, for firms like Apple, which have high (free cash flow) in relation to its capital base, share repurchases mean little in terms of enhancing shareholder value, even though the return on a large cash hoard is close to zero. In Apple’s case, economic profit is driving results, which, aside from product acceptance, is exceptionally high due to a very effective supply chain, including parts, technology services and assembly.

A leading indicator of management and Board effectiveness is the direction of the firm’s capital. Entities that have opportunities to deploy capital at rates consistently and safely above their cost have the opportunity to enhance shareholder value.  Unfortunately, most firms, as shown in the text box, rely on a surrogate cost of capital (stock beta) instead of metrics reflecting all known and possible risks to prospective free cash flows. For more information on this, see Security Valuation and Risk Analysis.

In acquisition analysis, the reliance on beta to depict cost of capital, managers and investors may be using inappropriate hurdle rates, thus unknowingly engaging in value destroying acquisitions.

Then there is the gray area, where, in fact most acquisitions fall. Such purchases may in fact be properly evaluated on the ROIC side but may raise cost of capital due to equity depletion, such that the firm is now constrained from engaging in prospective activities which may have added significant value relative to the recent material acquisition. This comment is of direct significance for entities engaging in excessive share buybacks, meaning the Board has approved the impairment to the financial structure.

It is to this latter point the balance of this article is directed, given my deep concern capital depletion will undoubtedly lead to subdued economic growth.  Believing the hype fed upon them by fear and greed, it is not uncommon to see firms commit a significant percentage of their free cash flows toward share buybacks, dividends and executive compensation (total direct compensation), instead of worthwhile projects and opportunities.

Firms such as Berkshire, Regal Beloit and P&G, have had long periods of successful acquisition programs due to their understanding of products, people, cash flows and risk, and by such virtue, have been rewarding shareholders. Former “high flyers’ often succumb to the falling stock price syndrome in the form of massive buybacks.

In this regard, technology firms could learn a lot from the manufacturing sector, which is not to say manufacturers have not made grievous errors, including the likes of GM, Exxon, and GE.

The Impact on Shareholders’ Equity

As a consequence of share buybacks, shareholders’ equity has, for many firms, including Sears, The Gap, and Wendy’s, fallen quite considerably from peak levels, despite strong cash flows and GAAP based earnings.  For firms in general, shareholders’ equity has risen just 17% for the S&P Industrials (see chart) from the March 2009 bottom.


For some well-known firms, the decline in shareholders’ equity has been dramatic, even  excluding material off-balance sheet liabilities such as pension plans and other benefits, operating leases and market value adjustments.


IBM-A Case in Point

IBM saw its shareholders’ equity peak in its September 2006 quarter at $34.3 billion.  Due to share repurchases it has been on a continual decline, currently standing (FYE 2011) at $20.2 billion, or 41% lower. IBM has placed the majority of its free cash flows into repurchases, boosting its GAAP metrics while its free cash flow growth since 2008 has been sub-par. If IBM’s economic return were to slow from its current level, its share price would fall greater than currently perceived due to the removal of its safety cushion. Would not IBM’s shareholders have benefitted more greatly if the company had not, over the past three years, spent two and a half times the value of acquisitions on share buybacks?  Sooner or later, IBM management must also come to grips with the underfunding of its foreign pension plans. Balance sheet pension (which is understated by at least 20%) liabilities grew by 11% during its past year and now accounts for over 90% the amount of shareholders equity. Investors have yet to focus on the liability for which, I am sure, IBM’s CEO is thankful. Although the company spent $33.4 billion on stock repurchases over the past three years, shares outstanding declined just 12% through September (2012 10-K not yet filed).

Invested Capital Steady Despite Fall in Equity


If IBM achieved 9% cash based ROIC return on the cash used for share buybacks, even allowing for the increase in shares resulting from issuance, its share price fair valuation would have increased by 23%, and, when the next downfall comes, its shares will have declined less.  Even if IBM had taken half the buyback to cut its pension liability, cost of capital would have declined by half a percent, adding about 12% to its shares fair value.

This point is illustrated as while IBM’s shareholders’ equity fell almost 13% from its year end 2010, its invested capital fell slightly for the year, $44.98 billion versus $ 45.45 billion. While IBM’s invested capital dropped from the 2006 level of $54.45 billion, such was due to the company’s shrewd exit from the PC business, and into software and consulting services. Over the past 5 years, IBM has altered its financial structure, now needing less of a financial cushion from the new business mix and other efficiencies. I believe, however, IBM, in its attempt to reach $20 per share in GAAP earnings, as it promised security analysts, it is taking on excessive risk while compromising worthwhile prospects, as is seen by its limited acquisition program. Meanwhile, its R&D budget has been flat for 5 years.

While supply chain and other streamlining aid cash flows, playing with equity as a means to reward shareholders is illogical. Shrinking equity will harm corporations as a whole, and, as such should be a concern to investors, analysts, creditors and lawmakers who may be considering following the IBM model. Recall only a few years ago to the worldwide financial crisis how important equity was to many institutions.

Perhaps Boeing shareholders would not have seen its stock price fall to below $30 in 2009 had the company not repurchased almost $3 billion of its shares during 2008, destroying equity. Boeing, which also has large liabilities not reflected in its financial statements, has yet to see its old highs. Its shares started recovering as its share repurchase program was halted and equity was rebuilt. Cyclical firms should almost always avoid share repurchases except for normalized free cash flow producers with low cost of capital wishing to offset share based compensation. Analysts must deduct those tax based effects listed under financing activities in the statement of cash flows in their cash flow models, such that the real impact of stock-based compensation is reflected, including tax affects.

I look forward to the day I hear investors grill companies on their misuse of capital. Today, revenue growth is the most desired metric.  Although product acceptance is of utmost concern, one must recognize it takes assets and capital to have that come about, something that is destroyed through capital depletion.

Kenneth S. Hackel, CFA

[1] Materiality is a function of the change in revenues, units, cash flows, employees, assets, liabilities, and other risk measures and security level metrics. See Security Valuation and Risk Analysis.