2 Companies With Share Buybacks That Work
Recently, I wrote an article in which I discussed the pros and cons of investing in companies that are repurchasing their own shares on the open market. In general, I have mixed feelings about it. There are a lot of cons: Many companies buy back stock to mask the fact that they are diluting shareholders by giving their executives stock option-based salaries.
Others borrow money to buy back stock when they shouldn’t be. Still others have masked weak earnings growth by buying back stock. If a company reduces the number of shares outstanding, then it makes the earnings-per-share number look better because the denominator — the number of shares outstanding — is smaller. Finally, there are companies that overvalue their stocks. Just because the buy decision is made by insiders doesn’t mean they understand the stock market.
The result is that there are many companies out there that have squandered shareholder capital through buybacks.
However, if it is executed correctly, a stock buyback program can generate a lot of value. Let us take a look at a couple of examples of quality buybacks that have generated shareholder value so that we can better understand what to look for in a share buyback program.
The first is Lorillard (NYSE:LO). Lorillard is America’s third-largest producer of cigarettes and tobacco products. The company has been aggressively buying back its own stock over the past several years, and the company did so at reasonable valuations. The stock had been depressed, as there were concerns that Lorillard’s top product — menthol Newport cigarettes — would be banned. This gave the company the opportunity to buy back its own shares.
Management has been very aggressive in repurchasing stock. In fact, they bought back so much that they borrowed money to do so, and now the company has negative net equity. I raised this concern in my previous article, but given the steady nature of Lorillard’s business, it can borrow money at a low interest rate. It has the capital it needs to pay back this debt if need be, and a lot of it isn’t due for many years.
Furthermore, the company has been supplementing its buyback with a dividend. This means that management is not just trying to use its buyback program to pump up the value of its shares. Rather, it is enhancing the dividend.
As the company buys back its own stock, it has to pay a smaller net dividend because it pays the same amount per share. This means when it comes time to raise the dividend, it is able to raise it more rapidly. As a result, the company has more than doubled its dividend since 2008 despite the fact that its actual profit growth has been modest.
Most importantly, however, Lorillard is not just blindly buying back its own shares. It has bought back less stock, or even no stock, if the stock price was high, and it has therefore been able to double down when the stock price falls.
The second company is CSX Corp (NYSE:CSX). CSX, along with many other railroad companies, buys back stock and pays a dividend in order to return capital to shareholders. CSX has been more conservative than Lorillard, but this doesn’t mean that the buyback program has been unsuccessful.
In fact, CSX’s conservative approach might be preferable for some investors, as it hasn’t added additional interest obligations, although it can certainly afford to do so. The company has reduced the number of shares outstanding by 10 percent over the past three years. This has helped to increase earnings per share, which has risen by more than 30 percent during this timeframe. Nevertheless, despite spending more than $4 billion on share repurchases, the company has managed to actually grow its net asset value.
Like with Lorillard, CSX has been sensitive to its share price when buying back stock. For instance, with the stock trading under $20 per share in 2010, the company repurchased $1.5 billion in stock. But last year, with the stock near all-time highs and with revenues from coal shipments flat to slightly down, the company reduced its repurchase program to just $344 million. If the share price falls, or if it stays relatively flat in the face of strong earnings, I expect this buyback rate to increase again — the company is amply capitalized to do so.
Note the following about the two companies that I have selected as model share repurchasers.
- Both companies pay dividends in addition to their buybacks. Furthermore, both companies raised their dividends even if they slowed down their buybacks.
- Both companies reduced the number of shares outstanding.
- Both companies had rising revenues and profits, so the buyback wasn’t meant to mask company weakness.
- Both companies stopped or slowed down their buybacks when their share prices were high.
- While Lorillard did take on debt to buy back its shares, neither company seriously jeopardized its financial health in order to reduce the number of shares outstanding.
While there are no specific rules for choosing companies that buy back their own stocks, I think that the attributes I point out above are indicative of quality buyback programs, and these are the attributes that investors should look for in a company that is buying back its own stock.
Disclosure: Ben Kramer-Miller is long CSX Corp.