Published: November 12, 2006
ONE force behind the stock market’s recent strength has been the flood
of money that corporate America has poured into share buyback programs. According
to Standard & Poor’s, the companies in its flagship 500-stock index
are on track to repurchase more than $435 billion worth of their shares this
year. That’s significantly more than the $349 billion repurchased in
2005 and more than triple the $131 billion in shares that were bought in 2003.
Many investors applaud the buyback binge, considering these programs entirely beneficial. After all, buybacks support a company’s stock price and buoy per-share earnings by reducing the amount of stock outstanding.
But less obvious to investors are the downsides associated with buybacks. By artificially inflating a company’s earnings per share, repurchases can mask business slowdowns, for example. Companies can hurt their financial positions by putting scarce cash into repurchases. And when buybacks are used to offset multitudinous stock option grants to corporate executives, an even more pernicious outcome can occur: the purchases may actually destroy shareholder value by forcing companies to essentially buy stock in the open market at high prices to cover shares sold at lower prices to executives.
Furthermore, it may not surprise you to learn, buybacks can wind up bolstering top executives’ compensation. A new study by Jill Lehman, a managing director at the Center for Financial Research Analysis, and Paul Hodgson, a senior research associate at the Corporate Library, makes these and other risks clear.
“If a company is generating negative cash flows prior to the buybacks it seems that they shouldn’t also be using cash to buy back those shares,” said Marc A. Siegel, director of research at the C.F.R.A. “With all the buybacks going on, we thought it would be interesting to marry up which companies might be executing fiscally unwarranted repurchases with companies where executives are being compensated on metrics that are benefited by buybacks.”
Thankfully, the study found only three companies that had negative cash flows over the past three years before accounting for the costs of their share reductions. They were Dominion Resources, Ryder System, and the Southern Company.
But the story definitely becomes more interesting as one looks at compensation practices among S.& P. companies making repurchases and generating negative cash flows as a result for the last two years. A total of 78 companies meeting those requirements popped up.
Of these companies, the study found, 33 used an earnings-per-share measure to analyze performance when determining executive pay — that’s about 42 percent. Among the S.& P. 500 as a whole, only 28 percent of the companies used that measure. Per-share measures, of course, are hardly exact barometers of financial performance because they can be greatly influenced by the reduction in shares outstanding associated with buyback programs.
This disparity makes one wonder whether some repurchase programs have been instituted to generate higher levels of earnings per share, thereby ensuring the payout of short- and long-term incentives.
The study found that chief executives at 89 percent of these 78 share-repurchasing companies received an annual bonus in 2005, compared with 78 percent of chief executives for all companies in the S.& P. 500.
In addition, companies in the group that use per-share performance measures were more likely to have paid a bonus to their chief executives last year. At the 33 companies using such measures, only 3 percent did not pay out an annual bonus in 2005; by comparison, 13 percent of the companies in the sample that did not use per-share measures failed to pay a bonus.
The median bonus among negative-cash-flow companies that have bought back shares was also a bit higher than it was in the S.& P. as a whole: $1,565,050 versus $1,487,800.
While earnings per share is a commonly accepted measure of short-term corporate performance, the study’s authors questioned its effectiveness in assessing long-term value growth. Nevertheless, some of the buyback companies use earnings per share to assess performance for both the short term and the long term, “a very poor governance practice resulting in the same set of performance achievements being rewarded twice,” the study said.
Eight companies did this: Eli Lilly, Hershey, Huntington Bancshares, Masco, Pitney Bowes, Procter & Gamble, Pulte Homes and Robert Half International.
The study said that none of the companies that engaged in share repurchases and used an earnings-per-share measure discussed in their proxies the impact of buyback programs on their pay calculations. Home Depot, a company that has been criticized for its pay practices, did the right thing starting in 2004 by excluding the effects of share repurchases during the performance period when measuring earnings per share for compensation purposes. But this year, the company said its long-term incentive plan would no longer be adjusted for the impact of share repurchases.
The chief executive’s incentive plan at Countrywide Financial, a mortgage lender that has engaged in buybacks, seems designed to get a big boost from earnings-per-share growth, the study said. While other executives at the company receive pay based on growth in its return on equity, Angelo R. Mozilo’s bonus is based solely on earnings per share. Mr. Mozilo has received bonuses worth $56.7 million in the past three years. Countrywide did not return a phone call seeking comment.
As buybacks have ballooned, the study said, some companies conducting the programs have changed their pay-for-performance targets to include earnings per share. In 2004, for example, Eli Lilly moved from a bonus plan that assessed changes in economic value at the company to one that measured moves in earnings per share.
Philip Belt, a Lilly spokesman, said his company’s buybacks were so small relative to its market value that linking the program to executive pay was ludicrous. “In the last two years, our total buybacks have been approximately half a billion dollars, a very small amount,” he said.
Spokeswomen for Masco and Hershey said that their compensation committees consider the impact of share buybacks when they set executive pay. And a Ryder spokesman said that the company’s negative cash flow position was a temporary imbalance because recent capital expenditures will generate revenues from contracts over time. He said the buyback program offsets stock grants and employee share purchase plans at the company.
Clearly, not all buybacks are created equal — at least for investors. And as the numbers of buybacks grow, the manner in which they may mask a company’s true performance becomes more problematic.
“We have a concern here that investors may not appreciate the full impact that the buyback has on the earnings per share,” said Howard Silverblatt, senior index analyst at S.& P. “When the buybacks stop, where is the growth going to come from?”
Adding to the anxiety about repurchases, Mr. Silverblatt said, is the fact that the shares have not been completely retired. The company can bring them back onto the market at any point; this would dilute existing shareholders’ stakes.
“What is the company going to be doing with these shares?” he asked. “It is an enormous amount of assets under control of management that has not been retired and could be put back into the market.” Using cash to pay dividends would be far preferable, of course, especially given the lower tax rates that apply to such payments. But managements are wary of dividends because, once they grant them, shareholders come to expect them.
Buyback programs look great from a distance. Up close, however, the picture blurs. More significantly, they may be a way for some corporate managers to think, once again, of themselves first and their owners second.