[The Wall Street Journal Interactive Edition]

July 7, 1997

Buybacks Aren't Always A Good Sign for Investors



Bullish about stocks after all those big share repurchases that have been announced? Think again. Companies continue to produce share-buyback plans at a torrid pace: So far this year, they have stated their intentions of removing as much as $87.3 billion of stock from the market, according to Securities Data Co. That comes hard on the heels of the $176.7 billion in stock repurchases announced last year. These buybacks, along with merger and acquisition activity, are eating away at the amount of stock available to investors. That, in the eyes of many stock-market analysts, is one of the main causes of the current bull market, which saw the Dow Jones Industrial Average soar 100.43 points to a new record of 7895.81 in Thursday's holiday-shortened session. But not all buybacks are created equal.
While buybacks as a whole have helped boost returns to stock-market investors as a class, companies don't always use them just to demonstrate that their stock is undervalued, or to distribute excess cash to shareholders, skeptics say. It has become increasingly important for prudent investors to sort through the hoopla surrounding individual share-repurchase plans to determine the reasons behind the buyback. Only then can they figure out whether a repurchase plan is a sign to buy -- or to avoid the stock. The Options Factor For one thing, companies are more active in buying back shares to offset growing numbers of options they are issuing to their employees. "The focus has been on the buybacks, but in many cases we as investors have simply been overlooking the other side of the equation," says Tim Morris, executive vice president of Bessemer Trust Co., a New York based money-management firm. "Yes, it's interesting if a company has been buying back its shares, but if with the other hand it's issuing shares through options, what's been gained here?"
The answer from some analysts is, not much. In a recent research report, the equity-strategy department at Salomon Brothers points out that while an employee usually buys shares for less than the market price under option programs, the company pays market price to buy them back. In dollar terms, the number of shares outstanding may seem to be shrinking, as the company has spent more to buy back shares than employees have spent to acquire them, but in fact the number of shares could remain unchanged or even grow. The report's authors argue that if stock issued under option plans for companies in the Standard & Poor's 500-stock index were accounted for at its market value, figures would actually show a net issuance of new stock, rather than a decrease. Salomon's View Salomon also argues that stock buybacks don't justify the market's lofty valuations. Dividends yields -- dividend payouts as a percentage of stock prices -- are at an all-time low of 1.7% for the S? 500. But many analysts routinely dismiss this signal of overvaluation by arguing companies are using buybacks instead of dividends to distribute cash to shareholders. In fact, Salomon's report found that adding cash received by shareholders from buybacks boosts dividend yields to only 2.2%, still the lowest in at least 22 years. "There's less there than meets the eye," says David Shulman, Salomon's chief stock-market strategist. In the 1980s, he says, buybacks took more stock out of the market. Today, he adds, "you're not getting the equity shrink you had in the 1980s, which was real." Intel's experience highlights the issue. Every year since 1992, the semiconductor manufacturer has bought back stock. But in 1996, for example, while it issued only $261 million of stock and bought back a whopping $1.3 billion of stock under its share-repurchase plan, its common and common-equivalent shares outstanding actually grew to 888 million from 884 million, Salomon notes. The reason? The company paid $77.38 a share for the stock it repurchased -- but received only $15.35 for each share issued through options. Some investors take pains to ensure that the benefits of a stock-repurchase plan are real. Kurt Feuerman, who manages about $4 billion in U.S. growth stocks for Morgan Stanley Asset Management, says he is a big fan of the way Wells Fargo handles its repurchase plan. The bank is consistently one of the most aggressive purchasers of its own stock, he says, putting most of its free cash flow to work every quarter to buy back between 1.5% and 2% of the shares outstanding. But when the bank's officials report quarterly results, "they give us two sets of numbers for shares outstanding, one of which is net of options issuance, and that's what they treat as the real number," he says. That way, Mr. Feuerman says, analysts and investors don't have to work their way through footnotes to financial statements, trying to figure out what the real impact of buyback and options programs has been.
Worry Over Borrowing
But it's not just the smoke and mirrors caused by the issuance of shares under options programs that undermine the usefulness of repurchase plans as a stock market indicator. Another factor is that many companies are now borrowing to finance buybacks. While such moves might have tax or other advantages, they simply replace equity with debt, which means shareholders get the buyback's benefits only at the expense of owning a more-leveraged company and the risk that an economic downturn could make it harder to service debt. In a recent research report, Robert Willens, a tax and accounting analyst at Lehman Brothers, cites Ipalco Enterprises, an Indianapolis utility holding company that in February cut its dividend 33% and arranged to repurchase $401 million of its stock, or 21% of the total outstanding, financed with new bank debt. The move, Mr. Willens says, would raise debt as a proportion of the utility's total capital to 68% from about 40% for at least the next few years. It also would transform the stock from an income stock to a growth stock, allowing shareholders to realize capital gains rather than a stream of dividend payments. As Congress debates a proposal to cut the rate at which capital gains are taxed, more companies could follow Ipalco's lead, making dividend yields even less important in valuing stocks, Mr. Willens believes. In April, SPX Corp., a manufacturer, said it would suspend its dividend completely and borrow to repurchase stock. Another manufacturer, Briggs & Stratton, supplemented a higher dividend payout with a share-buyback program based on borrowing, while last week children's apparel maker OshKosh B'Gosh announced a partly debt-financed buyback of 17% of its Class A shares for as much as $440 million. Even the strongest fans of share buybacks recommend investors scrutinize each case individually. "We've believed for a while that a high dividend yield by itself isn't attractive because it says a company can't find anything better to do with its cash," says Abby Joseph Cohen, U.S. market strategist at Goldman Sachs. While a share-repurchase program is still better for investors than dividends, "you need to apply the same kind of judgment as to whether this is the best use for this money." Mr. Feuerman, for one, wants to see growth prospects as well as buyback activity. He says he won't buy shares in a company if he believes its growth is plateauing, even if managers are boosting the share price through a buyback program. The higher a stock's price/earnings multiple, the less impact on per-share earnings a buyback will have. And he has bought stock in Home Depot, which doesn't repurchase its shares, because he believes it thus can use its capital better to expand its business. "There's been a real sea change in the way people think about what kinds of returns generate value for investors, and that has favored buybacks," he says. "But that's not the whole story."