It has become relatively common to read annual reports of companies that previously engaged in regular share buybacks yet mysteriously decided to halt the practice during 2009 even as share prices hit multi-year lows. As The Economist has noted, share buybacks are making a comeback in 2010 just as markets are approaching levels last seen prior to September/October 2008. Why is this happening now and how should shareholders evaluate management decisions on buybacks?
A Rare Skill Set
Shareholders employ a Chief Executive Officer with an expectation that he or she will intelligently run the business in a manner that is likely to maximize profitability over long periods of time. Over time and depending on the nature of the specific business, a good manager should be able to generate cash flow above and beyond maintenance capital expenditure requirements.
Operational excellence should ideally result in a growing pile of cash on a company’s balance sheet. However, simply because a manager is good at running a business and generating free cash flow does not mean that the manager will intelligently deploy the free cash flow for benefit of the company’s owners. Great operational managers are rare and so are great capital allocators. It is exceedingly rare to find a manager who is excellent in both areas.
Reinvest or Return Cash to Owners?
When a manager finds that cash is building up on the balance sheet, a choice must be made: Either the funds will be reinvested within the business or returned to shareholders. Reinvestment can be accomplished through internal growth or through acquisitions of other companies while returning cash to shareholders can take the form of dividends or share buybacks.
There are a number of factors that naturally predispose most operational managers to retain cash for reinvestment purposes:
First, excellent operational managers are normally optimists who have a history of seizing opportunities and finding success in areas where others may have failed. Accordingly, such individuals often have a healthy opinion of their own capabilities and feel that cash in their hands may be used in intelligent ways within their current business.
Second, it is natural for most managers to want to build up the size of the company they oversee in terms of annual sales, number of locations, number of employees, etc. When a manager says “I run a $10 billion company”, he is normally referring to annual sales volume rather than profitability. Just from an “ego” perspective, there is perceived value in running a larger enterprise.
Finally, and possibly most importantly, financial incentives often reward managers for growing the size of a business even if incremental returns on invested capital are substandard. If you start with a business earning high returns on capital, incremental investments at inferior returns will only show up slowly in overall results and only be apparent to alert shareholders who are paying careful attention.
Share Buybacks or Dividends?
In cases where the CEO (or the Board of Directors) has decided that there are no legitimate opportunities for internal investment, there are primarily two ways in which excess cash can be returned to shareholders: Share buybacks and dividends. Many managers prefer buybacks for a few reasons:
First, a buyback reduces the number of shares outstanding and can mask the effect of option grants to executives and others in the organization. In the absence of a buyback program, the share count of companies providing options to employees will creep up over time and make it more difficult for managers to achieve growth in reported earnings per share.
Second, managers who hold stock options have a clear incentive to favor buybacks over dividends. Paying dividends reduces the intrinsic value of options since cash is flowing out of the business to shareholders while the option strike price remains unchanged. In contrast, a share buyback effectively invests the cash on behalf of remaining shareholders in stock of the company itself which has a positive impact on option holders.
When Buybacks Make Sense
If a company has reached the point where free cash flow cannot be invested internally or via acquisition at acceptable rates of return, the cash should be returned to shareholders either through buybacks or dividends. Buybacks are only appropriate when management believes that shares are trading at levels under a conservative estimate of intrinsic value. When such buybacks occur, all remaining shareholders are better off because the intrinsic value of each share will increase and eventually be reflected in market prices. In contrast, shares purchased indiscriminately at any price can destroy value when managers buy shares at inflated prices.
This leads to the question of whether managers who were repurchasing shares in 2007 and 2008 at high prices but failed to repurchase shares in 2009 were acting in the best interests of shareholders. There are no blanket answers since each situation is different. Many companies that had positive free cash flow in 2007 and 2008 were burning cash in 2009 due to the economic downturn. Continuing a repurchase program even at lower prices could be ill advised if doing so depletes working capital that could cause financial distress or collapse.
When red flags should appear are cases where a company remained profitable and generated free cash flow throughout the economic downturn but mysteriously halted buybacks as the share price declined. Such managements should answer for why they considered it appropriate to buy back shares at higher prices in 2007 and 2008 but not at bargain prices in 2009. There could be valid reasons such as a desire to keep dry powder available for acquisitions made possible by distressed conditions or ensuring that the company builds up even more cash reserves in case of a longer recession or depression. However, the burden should be on management to explain this decision to shareholders in a coherent manner. Building up cash far in excess of any conceivable need to protect the business could simply indicate that managers were hoarding cash to sleep well at night at the expense of owners of the business.