Stock Buybacks: We Separate Smart from Dumb
Apple’s (AAPL) recent announcement that it will swap out last year’s $10 billion stock repurchase plan with a $60 billion buyback plan to be completed by the end of 2015 is just the latest (and biggest) move by a corporate board to up its pace of share repurchases. Merck (MRK) announced earlier this month it is eyeing a $15 billion buyback, IBM (IBM) plans to spend another $5 billion on stock buybacks, and Sirius XM (SIRI) announced a $2 billion buyback. Last year S&P 500 companies bought back $400 billion worth of outstanding shares.
When done for all the right reasons -- management believes the stock is undervalued and indeed makes repurchases when the stock is cheap not dear -- buybacks can be a good use of corporate cash. In Berkshire Hathaway’s (BRK.B) 2011 shareholder letter, Warren Buffett made it clear he was rooting for IBM’s stock price to languish in the near term so that Big Blue could repurchase more (cheaper) shares than if the stock price was en fuego. The benefit to Berkshire shareholders: as IBM’s outstanding shares decline, Berkshire’s share of earnings grows.
The naysayers point out that buybacks are often nothing more than C-suite financial engineering. Executives whose compensation is tied to short-term earnings targets can manufacture a nice showing by buying back enough shares to lift the per-share earnings without needing to have any organic growth in profits. As one market watcher put it, “Repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.”
Turns out, that was Buffett as well -- in the 1999 Berkshire Hathaway shareholder letter. And that illustrates the conundrum investors face: buybacks are increasingly popular, but not all buybacks are created equal in terms of producing shareholder value.
The fact that S&P 500 stock buybacks peaked at $589 billion in 2007 when the market was at an all-time high proves management can have a faulty timing belt. Just this week, Delta Airlines (DAL) announced a $500 million stock repurchase plan on the day the stock hit a five-year high.
Today’s slow growth world amps up the buyback machine. Without sharp revenue gains to propel earnings growth, buybacks can be a nice life preserver. As the Wall Street Journal laid out, Safeway (SWY) management used buybacks to help goose per-share earnings. As the chart below shows, earnings (EBITDA) have pretty much flat-lined since early 2012, while earnings per share jumped more than 60%. Aggressive cost cutting? Nope, as the chart shows, operating expenses haven’t fallen. But what has helped is an 18% reduction in shares outstanding, which goes a long way to goosing EPS.
The Journal also pointed out that Safeway’s CEO compensation is in part tied to EPS growth.
While Safeway was able to reduce its shares outstanding, many buybacks are simply to combat shareholder dilution: buyback shares today to counteract new shares you floated in the past.
In early May, Standard & Poor’s announced a new index that will follow the 100 stocks within the S&P 500 with the highest buyback ratio. That’s the aggregate value of shares repurchased over the past 12 months as a percentage of a firm’s market cap. At YCharts this is called Net Buyback Yield. Firing up the YCharts Screener you can choose the S&P 500 under the All Companies drop down on the left (Choose Indexes and then S&P 500 will pop up to the right). Then you can filter the list by adding Net Buyback Yield on the right side of the screen. Under “Add a Financial Metric” choose the Fundamental Ratios/Calc dropdown, and from there you can find “Net Buyback Yield TTM.” Click on that column header in the screen below and you’ll have the S&P 500 ranked by their buyback ratio.
Apollo Group (APOL) tops the list with a buyback ratio above 21%. Thing is, all that repurchasing hasn’t exactly made a dent in outstanding shares, which declined by less than 1%.
Apple’s new-found buyback zeal also has a dilution angle. Until a year ago, Apple didn’t have to sweat dilution issues as the stock’s soaring earnings and stock price trumped all. But in fact, as the chart below shows, a whole lot of stock option grants over the past decade triggered a sizable increase in outstanding shares.
Bringing that share count down can only help at this point. And management can’t be accused of buying at a high, as the stock is off 15% over the past six months. Moreover, Apple’s price-to-book value has declined 25%, and is now right about where it was back in 2004.
YCharts tools can help separate the financial-engineering motivated buybacks from the more fundamentally sound “we’re undervalued” crowd. A stock screen ranking the S&P 500 by the dollar value of buybacks over the past 12 months, shows Exxon-Mobil (XOM), AT&T (T) and Johnson and Johnson (JNJ) at the top of the list. Create a stock chart of shares outstanding for those three and it turns out that Johnson & Johnson’s aggressive buybacks were to prevent dilution caused by its use of shares to finance part of its $19.7 billion acquisition of medical device manufacturer Synthes. Even with nearly $13 billion spent on buybacks over the past 12 months, Johnson & Johnson’s share count still rose 2% over the past 12 months compared to declines for Exxon Mobil and AT&T.
Turning back to the YCharts Stock Screener, by adding profit and valuation filters, you can see EBITDA declined for Johnson & Johnson over the past three years, while Exxon Mobil’s grew by more than 30%. Moreover, Exxon Mobil trades at a below-average 12 forward PE ratio, while Johnson & Johnson is near 16. The S&P 500’s forward PE is 14. While both Exxon Mobil and Johnson and Johnson were buyback leaders, a check under the hood makes a more compelling case for Exxon Mobil.
Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at firstname.lastname@example.org.