I’ve been writing for a couple of years now about an impending cataclysm about to hit company earnings, cash flows and credit. As we know, many firms were bailed out from having to make stepped-up contributions thanks to the large rally in the financial markets in 2009.
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Regardless of how the current earnings season is “spun”, given a boost to operating cash flows (regardless of how “manufactured), we should see an incentive to set up, or re-instate, share buybacks. The folly of buybacks have proven substantial over the past four years, including the large number of firms that have subsequently re-sold the same securities at much lower prices; investors continue to falsely believe in the information content stock buybacks hold.
It is not unusual for buybacks to take place even though free cash flow is subpar, with these entities borrowing to engage in a buyback program.
Share buybacks have been traditionally viewed as an outlet for free cash flow and excess balance sheet liquidity with the intent of bolstering a firm’s valuation. By shrinking the equity base and number of shares outstanding, it is believed, the firm would enhance its earnings and cash flow per share, economic profit, and hence its market valuation. As has been seen by the number of companies which bought back significant amounts of their stock for treasury, and later returning to investors to sell back shares at a considerably lower price, share buybacks are often a poor choice. The loss of financial flexibility and equity cushion was a central reason for the demise of many firms which had acquired large amounts of their own stock during 2007-2008. For most firms, share buybacks are used to offset the dilution resulting from stock based compensation.
Financial theory states that companies that shrink equity by buying back shares or paying of dividends with balance sheet cash and new debt tend to see their cost of capital decline. This occurs for two reasons.
The first has to do with the mystery of what management might wind up doing with the cash. Too often, bad acquisitions burn cash or lower return on invested capital, waste management time and increase leverage. This most often occurs when companies acquire outside of their own industry (Mobil, Montgomery Ward), but also when firms seek to diversify outside of their core competency from within their industry (AT&T, NCR).
As stated in the 2009 10K of Perrigo Inc. (PRGO):
As part of the company’s strategy, it evaluates potential acquisitions in the ordinary course of business, some of which could be and have been material. Acquisitions involve a number of risks and present financial, managerial and operational challenges. Integration activities may place substantial demands on the company’s management, operational resources and financial and internal control systems. Customer dissatisfaction or performance problems with an acquired business, technology, service or product could also have a material adverse effect on the company’s reputation and business.
The other benefit concerns the tax shield of interest payments. Using excess balance sheet cash to pay common stock dividends does not change the cost of capital, according to popular finance, as payment is made after taxes, and the entity receives no tax benefit as does a credit against taxes for interest expense. It is the tax shield of interest expense which reduces a firm’s cost of (debt) capital since profits paid to creditors in the form of interest are not taxed. Unlike financial theory, if a firm paid a dividend through borrowing, it could raise cost of capital in our credit model because of the increase in leverage and debt metrics.
The Chapter 8 credit model would not lower cost of capital due to a stock repurchase program. It does not provide cash flow and reduces financial flexibility. It has been observed, in widespread practice over the course of several business cycles, such programs actually wind up raising cost of capital more often than lowering it.
Entities buying back stock in the midst of a large capital spending program significantly raising leverage ratios would be especially prone to increases in their cost of debt and equity capital. Business runs in cycles and even investment grade companies, like Home Depot, have seen higher cost of capital resulting, in part due to large stock repurchases.
Seen too often are share buybacks forced upon management by aggressive and vocal shareholders, hoping a share repurchase program will either support the stock or allow them the flexibility to sell their holdings.
But what if the entity has surplus cash on its balance sheet, low leverage, no promising investment opportunities, and is a consistent producer of free cash flow? Rather than continually shrinking its equity, which has not shown to improve stock valuation, shareholders are best rewarded changing management who can find worthwhile opportunities either within or outside of the firm. Providing cash to selling shareholders has not proven to improve the wealth of the remaining shareholders if ROIC falls below cost of capital.
The road to superior stock performance has always been for management to raise the ROIC, not stock buybacks. Berkshire Hathaway (BRK.A) was a slow growth, stable free cash flow producer until new management arrived, deploying excess cash at every opportunity to buy high ROIC companies, finding hundreds of opportunities, from very small to very large, including furniture manufacturers, newspapers, brokerage, food, and now a railroad. Despite Berkshire outperforming the S&P by a huge margin, Berkshire has never repurchased its own shares. And even today, being a company with a $195 bn. market value, the company is finding no shortage of investment opportunities, of the kind that are generally available to all investors.
BUT BUYBACKS DO NOTHING TO IMPROVE ECONOMIC RETURN
Aside from the probable loss in financial flexibility, do share buybacks otherwise improve valuation? Take the case of a hypothetical company, Worldwide Electric Co. Think of Worldwide as having two parts, (1)the operating company which produces $ 100 mil in annual free cash flow, and (2) Worldwide’s cash and cash equivalents ( 14.3% of equity) which can be used to buy back its shares. The firm has $100 mil in payables and no other liabilities.
Assume the company generates $ 100 mil in free cash flow (putting aside taxes), with a market value of $ 1.3bn. and 100 mil shares outstanding, so they generate $ 1.00 per share ( including interest), and the stock sells at $ 13 per share.
If they were to use their $100 million in cash to buy back 7.7 mil million shares (at its current market price), the multiple on its shares would fall to that of the operating company, or 12.5, and the company would now have approximately 92.3 mil shares outstanding.
Worldwide’s return on invested capital would remain exactly the same as we exclude interest income from our metric; we are only interested in the cash on cash return. While their GAAP ratios would fall, including the P/E, as a result of the reduced number of shares outstanding, the more vital cash flow return ratio is identical. And by that measure, the company still produces $ 96mil in free cash flow on the same capital base, or a 13.4% return on invested capital. The only differences are the shares outstanding and the reduced cash. If Worldwide had a greater amount of cash on its balance sheet to repurchase stock, the fall in P/E and free cash flow multiples would be more dramatic and yet the return on invested capital would still remain the same 13.4%. The free cash flow multiple falls to that of the operating company, so from the shareholders point of view, their value is not enhanced. And certainly lost is their financial flexibility. If they had balance sheet debt or operating leases, their debt ratios would have increased in addition to the elimination of cash which might have been used for expansion as a low cost of capital.
Under typical circumstances, as we see in our example to follow on Clorox, a large stock buyback can completely eliminate shareholders equity.
|WORLDWIDE ELECTRIC CO.|
|BEFORE BUYBACK||AFTER BUYBACK|
|Property, Plant& Equipment||700||700|
|Market Value of Operating Co||1,200||1,200|
|Value of Cash||100||0|
|Free Cash Flow-Operations||96||96|
|Interest Income-tax free||4||0|
|Free Cash Flow||100||96|
|Free Cash Flow per share||$1.00||$1.04|
|Free Cash Flow Multiple||13.0||12.5|
|Return on Invested Capital||13.4%||13.4%|
- New Era of Buybacks, Dividends and Mergers?
- CFOs Making the Same Mistake Again-Stock Buybacks;
- Pensions-Buyer Beware-These Firms Exposed to Greater Risk
- The Folly of Stock Buybacks-Part II
Kenneth Hackel, C.F.A.
CT Capital LLC
For additional information, please pre-order, Security Valuation and Risk Analysis, out this fall from McGraw-Hill.
 For example, a Wall Street Journal article, “America’s New Cash Conundrum,” January 21, 2010, pointed out that over the prior ten years, over half of the companies surveyed had a zero or negative return on their stock repurchases.
If the equity market were to rise less than 7% this year, the following firms would be particularly impacted. Column 3 shows some firms have expected returns of 9%, which would appear particularly optimistic, especially since all firms on the list have plans that are underfunded by at least $1bil. and have a substantial asset allocation to equities.
Disclosure: No positions