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JANUARY 15, 2015
U.S. Share Buybacks Rebound but Face Sharp Criticism
U.S. companies repurchased $144 billion in shares during the third
quarter of 2014, according to our latest Buyback Scorecard, but the
effectiveness of the strategy has been called into question.
By S.L. Mintz
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LEFT TO RIGHT: BILL PLUMMER, MIKE DEWALT, WILLIAM
LAZONICK |
In
late November, Yum Brands offered a twofer: The fast-food company said
it would rev up stock buybacks by $1 billion through May 2016 and
boost its dividend rate by double digits. Yum’s moves are part of a
corporate strategy that companies continue to pursue whether they’re
good at it or not.
Yum did get some instant gratification. Investors bought its stock,
which had been down slightly for the year. Shares in the Louisville,
Kentucky–based company, which operates KFC, Pizza Hut and Taco Bell
restaurants, inched up after the announcement and continued higher for
the next eight days.
Still, short-term stock gains won’t alter a sluggish track record in
buyback return on investment. In the latest ranking of our quarterly
Corporate Buyback Scorecard, developed and calculated by Fortuna
Advisors using Capital IQ data for the quarter ended September 30,
2014, Yum trailed the buyback return on investment of some 248
companies. Only 35 companies fared worse, among them two fast-food and
casual-dining companies, Oak Brook, Illinois’s McDonalds Corp. (No.
266) and Orlando, Florida’s Darden Restaurants (No. 269), as well as
companies in consumer services.
The Corporate Buyback Scorecard answers a straightforward question
many investors have about companies that repurchase their stock: How
do buybacks stack up against other investments companies make with
shareholders’ money? The two-year window the scorecard uses to judge
buyback programs matches the time period that companies often employ
to judge other major expenditures, such as capital investments or M&A.
One quarterly scorecard is not sufficient to render a final verdict on
the quality of management, notes Fortuna CEO Gregory Milano. But
lackluster performance will stir debate about the merits of buybacks,
strategic judgments and potential conflicts.
Robust buyback ROI stands out. At Stamford, Connecticut–based United
Rentals (No. 4), which joined the top ten in the latest scorecard,
timely buybacks chalked up a 79 percent ROI, albeit with a big lift
from surging gains in the underlying stock. United chief financial
officer William Plummer welcomes scrutiny. “It’s perfectly legitimate
to challenge the process,” he says. “It’s well worth asking, ‘What’s
the thought process, why are you doing them, and why will it help the
shareholders?’”
Adjusting the time frame can affect buyback ROI for better or worse,
though four more quarters would not help Yum. Since the third quarter
of 2013, the company has dropped 34 places on the scorecard, and its
buyback ROI does not compare well against its peers and the S&P 500
median. Over 12 quarters Yum recorded 8 percent in buyback ROI,
compared with a 29 percent median for its peers.
S&P 500 companies whose buybacks exceeded 4 percent of their market
cap reported $144 billion in stock repurchases in the third quarter of
2014, beating the $115 billion in the second quarter and $128 billion
in the third quarter of 2013. Median buyback ROI dipped for the third
scorecard in a row as companies faced headwinds. Although stock prices
mostly continued on an upward trek in 2014, spikes in market
volatility made executing buybacks trickier.
Buybacks made before share prices fall hurt ROI. Buyback effectiveness
measures that impact and compares buyback ROI with buyback strategy, a
proxy for total shareholder return. Barely positive for the second
quarter, buyback effectiveness went negative in the third-quarter
scorecard.
Companies in the technology hardware and equipment sector posted the
top buyback ROI: 38.1 percent. But with median buyback ROI below 7
percent, telecommunications services companies landed in the basement.
Dallas-based Southwest Airlines has long had an
excellent record of buyback ROI effectiveness and led the pack the
pack with ROI just shy of 100 percent. New York luxury retailer
Coach’s negative 31 percent buyback ROI trailed that of every other
company, hobbled by poor timing that exacerbated the impact of a
sinking stock price.
Huge investments that drag down performance ordinarily do not appeal
to investors. But laggard companies such as Armonk, New York–based IBM
Corp. (No. 261) and New York’s Pfizer (No. 254) keep aggressively
buying back shares anyway. The two companies retired 16 percent and 8
percent of shares outstanding, respectively, with subpar results in
the latest scorecard, notes Fortuna analyst Joseph Theriault. Both
companies unveiled more buybacks after the third quarter ended: $11
billion by Pfizer and $5 billion by IBM. Like gamblers who regularly
up the ante, companies that are down often sink more money into
buybacks in hopes that their fortunes will revive.
Economics professor William Lazonick at the University of
Massachusetts Lowell is critical of buybacks. “Buybacks are just a
manipulation of the market,” he charges. Ever since the Securities and
Exchange Commission gave companies the green light to buy back stock
in quantities large enough to affect stock prices, in the early ’80s,
Lazonick says, managers have used the strategy to inflate earnings per
share and get rewarded for it at bonus time.
One of Lazonick’s cases in point: San Jose, California–based Cisco
Systems (No. 170). “It should be the world’s leading technology
company,” he declares. “It’s not even innovative anymore.” Cisco, he
says, has shoveled gains into buybacks rather than into investments
that spawn innovation. Company officials might beg to differ with this
assessment. In fiscal years 2013 and 2014, Cisco devoted $12.2 billion
to R&D on networking products and services. In 2010 through 2012 only
five companies in global computing and electronics spent more, notes
Strategy&, a PriceWaterhouseCoopers publication. In the same
period Cisco spent a nearly identical sum on buybacks.
Lazonick mounted an assault on buybacks in the September 2014
Harvard Business Review: “Profits Without Prosperity” marshals
historical evidence that buybacks shift rewards to shareholders who
contribute nothing other than a liquid market for shares rather than
rewarding workers for increasing productivity. Lazonick includes
buybacks in his larger critique of economic inequality and excessive
corporate pay.
In
his scenario wages stagnate, jobs disappear and managers forgo risk as
higher earnings unlock stock-based compensation and buybacks and
dividends keep rising. “While the top 0.1 percent of income
recipients, which include most of the highest-ranking corporate
executives, reap almost all the income gains,” he writes, “good jobs
keep disappearing, and new employment opportunities tend to be
insecure and underpaid.”
Lazonick, a Harvard Business School graduate, criticizes three
justifications for buybacks. Conceding “some sense” in the argument
that buybacks may invest in undervalued shares and signal confidence
in the future, he notes a persistently different reality over the past
two decades. Companies ramp up buybacks in bull markets and reduce
them in bear markets, a trend in evidence today as buybacks continue
to occur.
Lazonick rejects buybacks as a way to offset EPS dilution from stock
options. He has calculated the impact of broad-based stock option
programs at high-tech companies and sees no logical economic rationale
for repurchases that offset dilution. “Options are meant to motivate
employees to work harder now to produce higher future returns for the
company,” he says. “Therefore, rather than using corporate cash to
boost EPS immediately, executives should be willing to wait for the
incentive to work.”
Last, Lazonick brushes off contentions by mature companies that in the
absence of sound investment ideas, buybacks return excess cash to
shareholders in a tax-efficient way. Not so, he says. In 2003,
Congress equalized tax rates on long-term capital gains and dividends.
Large, well-run companies enjoy competitive advantages over fledgling
businesses. Using tax treatment to justify buybacks should sound an
alarm, Lazonick says: “It raises the question of whether these
executives are doing their jobs.”
The conventional wisdom about buybacks is that they are an efficient
mechanism for shifting capital from companies that can’t invest it
well to those that can. Reasonable observers may ask whether returning
capital to shareholders serves the economy better than ill-fated
investments. It might not, warns economist Dean Baker of the
Washington-based Center for Economic Policy and Research. By putting
money in workers’ pockets, investment spurs spending on consumer goods
and services even if it doesn’t pan out. Buybacks create economic
demand only when shareholders decide to spend money. More often than
not, they reinvest the money rather than spend it.
“If we were at full employment, then the impact on workers would be
pretty much the same,” Baker says. Some demand would be pulled away to
support either poor investments or shareholder consumption. “However,”
Baker adds, “if we are below full employment, as is certainly the case
now, we would much prefer the failed investment.”
Lazonick’s recommendation? Reform the system by ending open-market
buybacks, reining in stock-based pay and transforming boards that set
executive compensation. “If Americans want an economy in which
corporate profits result in shared prosperity,” he says, “the buyback
and executive compensation binges will have to end.”
One thing is clear: An end to open-market buybacks and compensation
tied to EPS would eliminate conflicts that Lazonick contends are rife.
To test the impact of stock buybacks on incentive compensation,
consultant Jeff McCutcheon at Board Advisory, a firm that specializes
in advising boards on incentive compensation, examined 21 companies at
which buybacks reduced market capital by more than twice the median.
These companies stand out because the magnitude of buybacks had the
most pronounced impact on EPS, the most common incentive compensation
trigger.
In
the sample group that McCutcheon reviewed, buybacks appeared to
release incentive compensation tied to EPS at five companies: Santa
Clara, California’s Citrix Systems (No. 100); Corning, New York–based
Corning (No. 61); Short Hills, New Jersey’s Dun & Bradstreet (No.
134); Ireland-based Ingersoll-Rand (No. 111); and New York’s L-3
Communications Holdings (No. 108). The estimated effects on
compensation weigh the present value of future earnings, free cash
flow, pre- and postbuyback prices and cash used for buybacks.
The impact of buybacks on incentive compensation at Ingersoll-Rand and
Corning could not be calculated using disclosed information. At
software developer Citrix, which had retired 18 percent of its market
cap, four additional cents of EPS resulted in a cash incentive award
of $634,608 for CEO Mark Templeton. At D&B buybacks that retired 21
percent of market cap upped the compensation for former chair and CEO
Sara Mathew and current CEO Robert Carrigan by $321,750 and $82,875,
respectively.
After exceeding its 2013 EPS goals, thanks mostly to buybacks that
trimmed market capital by more than one third, L-3 rewarded CEO
Michael Strianese with substantial cash and stock payments. Based on
the disclosed pay program, McCutcheon estimates EPS performance from
the share buyback increased Strianese’s cash bonus by roughly $800,000
and boosted shares earned by roughly $2 million. L-3, a prime
contractor in aerospace systems and national security infrastructure,
outperformed median buyback ROI in the latest ranking. On December 4,
L-3 unveiled an additional $1.5 billion buyback program.
So
long as corporate bylaws allow them, buybacks that increase executive
compensation violate no laws or regulations. Executives at Citrix, D&B
and L-3 would not comment beyond what their companies reported in SEC
filings.
Pressure to return capital to shareholders has gained momentum, but
companies such as Caterpillar (No. 107), based in Peoria, Illinois,
insist that other needs be met first. “We want to increase the
dividend, we want to fund growth, we want to keep the credit rating
single A,” Mike DeWalt, who heads financial services, told analysts at
a recent conference sponsored by Credit Suisse. But, DeWalt says, cash
remains: “If we found a good way to invest the money, whether it be
organic or inorganic, we would do that. If we don’t, the safety valve
for cash, if you will, is a buyback.” Last July, Caterpillar announced
plans to spend $2.5 billion on buybacks, part of a $10 billion buyback
authorization that is twice the cash the company devoted to equipment
on operating leases and other capital expenditures during 2011, 2012
and 2013.
Critics who paint all buybacks as an assault on shareholders have it
wrong, says Deutsche Bank analyst George Hill. Hill follows McKesson
Corp. (No. 10), which has delivered solid buyback ROI since the
scorecard’s inception in the second quarter of 2012. The company’s
strategy, Hill says, centers on growing McKesson, not shrinking it.
Provided buybacks are part of a prudent approach to capital
deployment, any favorable impact on the stock price that helps
managers also helps shareholders. Hill rebuts the charge that paying
for stock when prices are high invites catastrophe. “The risk that
McKesson goes down and repurchases look like a poor decision is a
possibility,” he says. However, he adds, San Francisco–based McKesson
and other companies must make decisions about excess capital when
circumstances may be beyond their control.
Buybacks rooted in EPS impact or market timing can be problematic,
warns United Rentals’ Plummer. “Never do I ask if our stock price is
up or down on a given day,” he says. “Neither do I ask if it will help
our EPS or growth in EPS. In my view, those are specious reasons for
doing share repurchases.”
As
a company with revenue tied closely to construction cycles that
doesn’t pay a dividend, United Rentals uses buybacks as a tool to
manage its balance sheet and reward investors when cash allows.
Repurchasing
United Rentals’ shares ahead of a surging stock price generated
hedge-fund-like returns. When timely stock buybacks post whopping
gains, shareholders and top executives can celebrate wins all around.
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