2 Lousy Stock Repurchase Programs
I recently wrote an article in which I discuss the pros and cons of stock repurchase programs. I then followed this article up with another in which I point out two successful buyback programs — that of Lorillard (NYSE:LO) and that of CSX (NYSE:CSX).
Both of these companies bought back stock while their revenues and profits were rising. It also paid and raised its dividends while it was buying back stock. Each company has strong, predictable businesses that don’t require it to keep large amounts of capital on hand. Finally, the two companies slowed down its repurchases when its share prices rose. In short, the two companies used buybacks to generate shareholder value.
But while we can point to these success stories in order to justify buybacks, we need to address the dark side of share repurchases. One thing that a share repurchase program can do is increase the stock price in the near-term. This spike often drives in speculators and momentum traders who are interested in short term gains. Unfortunately, in such scenarios we can find dishonest executives and fund managers taking advantage of these short-term price spikes in order to unload stock.
When you look at a company with a share repurchase program, you need to make sure that the company is not defending its share price or buying stock from insiders. In order to spot these share repurchase programs that destroy value, we should take a look at a couple of examples.
The first is Hewlett-Packard (NYSE:HPQ). When this stock started trending downward, the management team decided that the market was incorrect, and that it was going to start to repurchase stock. In the fiscal years ended 2010 and 2011, the company bought back an incredible $18 billion worth of stock. This turned out to be a terrible decision, as the company wound up buying its shares at about $40 each while the downtrend took HP shares down to as low as $12/share.
HP’s management didn’t realize the extent to which its business would be hurt by the commodification of personal computers and related equipment. This ate into its profit margins. Had management foreseen this, it could have waited in order to repurchase its shares, and it would have been able to buy substantially more stock at a lower price.
This is a case of bad judgment; HP’s management thought it was doing the right thing by buying its own stock at $40/share even though this turned out not to be the case. Nevertheless, we can look at our positive buyback examples and compare them with HP’s buyback to see where the latter company went wrong.
First, HP was buying back its shares with declining revenues and declining margins. Lorillard and CSX were buying back stock when their businesses were growing. HP failed to see the extent to which its business would decline, and it appears that management tried to mask an earnings per share decline by repurchasing stock.
Second, HP was extremely aggressive when its stock was high. CSX and Lorillard were not. Of course, HP shares were down from their 2010 high when they started aggressively buying stock, but the size of the buyback in the face of a sinking share price leads me to suspect that the goal of the buyback was, in part, to defend the share price. This makes no sense; a company buying back its stock should want a lower share price, as this enables it to buy back more shares and to generate more value for its shareholders.
Finally, HP paid a paltry dividend. In the two years in which HP bought back $18 billion in stock — 2010 and 2011 — it paid less than a tenth of this amount in dividends. For all of these flaws, however, at least HP’s buyback could be descried as an honest mistake on the part of management.
The case of ADT (NYSE:ADT) is far more suspect. ADT repurchased a whopping $1.2 billion worth of stock in the fourth-quarter of 2013. That’s a lot for a company that only made $421 million in its fiscal 2013. Furthermore, the company repurchased the shares owned by hedge fund manager Keith Meister through his fund Corvex Management. Meister joined the ADT board after taking a 5 percent stake. When the stock was trading in the mid $40’s last November, ADT bought back the shares held by Meister, who subsequently quit the board. The stock immediately began to fall after this. When ADT reported its earnings a couple months later, the results were very disappointing, and the stock fell 17 percent. It trades today at just $32/share.
Given this sequence of events, it appears that ADT’s buyback was designed to benefit one of its board members, and not shareholders more broadly. While there is no evidence of foul play, we again see problems with the buyback that distinguish it from the quality buybacks of Lorillard and CSX. First, the company was extremely aggressive in buying back stock with the price just 10 percent off of an all time high. Second, the buyback dwarfed ADTs dividend. Third, the buyback was carried out while the company’s margins were declining, and this suggests that management was more interested in defending the stock price than in generating shareholder value.
Investors who like the idea that a company can generate value for long-term shareholders through stock buybacks should consider these two examples and apply its lessons to future investments.
- Buybacks are better used as a dividend supplement rather than a dividend alternative.
- Buybacks are a lousy idea when business is weakening.
- Buybacks should be more aggressive at lower share prices and management should slow down or cease the program when its company’s stock rises.
If you limit your investments in companies that follow these simple rules, then you will be less likely to be a victim of a lousy buyback.
Disclosure: Ben Kramer-Miller is long CSX Corp.