Mark Hurd, the new CEO of Hewlett-Packard (NYSE: HPQ), recently announced his company would buy $4 billion worth of its own shares. That call came just as Microsoft (Nasdaq: MSFT) finished buying up $4.3 billion of its own stock in the second quarter, a period in which Intel (Nasdaq: INTC) and Cisco (Nasdaq: CSCO) each snapped up $2.5 billion of their own stock. Up here in Canada–where buybacks are known as “normal course issuer bids”–Brascan Corp. (which is soon to be renamed Brookfield Asset Management Inc.) joined the party in September when it announced it will buy back $500 million in stock.
That's a lot of companies buying up a lot of their own stock. And it's indicative of a new corporate commandment on Bay and Wall streets of late: When blessed with profits, thou shalt buy back stock.
According to recent numbers from Standard & Poor's, total earnings of companies in the S&P 500 in the second quarter of this year were $167.2 billion, of which $81 billion was used to buy back stock. That's an increase of 92% over the second quarter of 2004, when $42 billion was spent on buybacks. “These are astonishing numbers,” says Howard Silverblatt, the New York-based S&P analyst who compiled the data. “It's a significant increase.” It's even more significant when you consider that 2004 brought a 100% increase in share buybacks over 2003, according to a recent McKinsey and Co. report.
So what's with all the trading by corporate North America? One explanation is that companies are sitting on a lot of cash, as they round the top end of the profit cycle that followed recovery from the bubble-burst of 2001. “We're coming off three years of good profit recovery, and companies have a lot of cash right now,” says Laurence Booth, a finance professor at the University of Toronto's Rotman School of Management. “The cash balances are huge, and they're asking, 'What do we do with this cash?'”
In the past, the answer has often been “merge and/or acquire.” The first instinct of managers is to keep any extra money inside a company and see if they can boost earnings through M&A activity. But it's also been shown that corporate mergers and acquisitions often end up working against the interests of shareholders, as managers grab whatever they can at whatever price. (Carly Fiorina's forced HP/Compaq merger, anyone?) No wonder Hurd is going big with a $4-billion buyback: it's become a signal for “I'm a good investment.” Says Booth: “Managers seem to be resisting the urge to do M&A. So that's good. I'd prefer they give the money back to the shareholders.”
When companies go into the market and scoop up their own shares, they decrease the outstanding share count. That means earnings are distributed among fewer shares, raising earnings per share, and thereby working to raise the share price–or so many investors assume. As a result, shareholders typically applaud buybacks, in part also because they widely assume that a buyback signals management's belief the stock is undervalued. As a result, few have complained about the current round of buybacks, which has reduced the total number of shares outstanding in the S&P 500. According to the S&P data, 141 of the issuers in the 500 index significantly reduced their share count this past quarter–a 33% year-over-year increase in the total number of issuers who did so. “An enormous number of companies are reducing their share count,” says Silverblatt.
But is this really a huge improvement over M&A? Not necessarily, according to Richard Dobbs, a McKinsey partner who led the research on the 2004 buybacks. He and co-author Werner Rehm wrote an article recently for The McKinsey Quarterly that suggests boosting earnings per share through share buybacks may not directly result in real long- term value creation.
Consider what happens if you spend the profits of a company to buy up shares. The earnings will be distributed among fewer shares, leading to higher earnings per share–that's true. But that does not intrinsically justify a share-price increase, since the company's price-to-earnings ratio should go down, as the equity value of the company goes down–since it has taken cash off the table, but its operations remain the same. Setting aside the market sentiment (which tends to view buybacks as positive signals and so drives up the price) and tax effects, Dobbs and Rehm argue that any intrinsic positive price effect of buybacks should be offset by the decline in P/E. “The impact is similar,” they write, “if the company increases debt to buy back more shares.”
On the phone from London, England, Dobbs says that “share buybacks are a good thing–companies can do silly things with cash. But I think there is a real risk now that managers might be doing too many buybacks, rather than going out and looking for long-term investments.” Dobbs points out that board compensation committees often tie compensation targets to earnings per share. And he goes on to relate this recent, disturbing anecdote: “A CFO was saying that all he had to do now to hit his EPS target was to figure out how many shares to buy back.”
So has the share buyback become just the latest way for managers to manipulate financial results to hit compensation milestones? “I'm not saying it's a problem, but we'll see who manages long-term growth,” says Dobbs. “The real issue here,” he adds, “is that investors need to challenge boards around the metrics used to determine compensation and around the reason for the buybacks.”
And the sooner the better. According to Silverblatt, there are still billions sitting in corporate coffers waiting to be spent. “We believe buybacks,” he says, “will continue to be strong through 2006.”