With many stocks trading well below their 12-month highs, finance executives are on the spot. Do they support their "undervalued" stock with an aggressive buyback? Or do they hang on to their cash in case the market is right?
Finance executives' confidence in their companies is being tested big time in 2001. The off-and-on bear market has pushed the stock prices of many corporations well below their 12-month highs, unleashing moans that the shares are undervalued. Do finance pros back up that opinion by aggressively buying back their cheap shares? Or do they cautiously consider that the market might be right and save their cash and borrowing capacity for harder times that might await them?
Buybacks have long been considered a powerful message. The people who know the company best are so confident that its shares will be worth more in the future that they think buying them back with corporate cash is a shrewd investment. "You do it to increase earnings per share and create more demand for your stock, which helps to buoy the price," declares Cliff Neimeth, co-chair of the national corporate and securities practice at law firm Greenberg Traurig LLP, New York City. But there's sometimes another motivation behind buybacks, he adds. Companies with depressed stock prices sometimes purchase their own stock to make themselves less attractive as takeover targets.
Businesses also use buybacks to distribute excess cash to shareholders. Repurchasing shares is a better tax strategy than issuing a dividend; investors pay a 20 percent capital gains tax on a repurchase but as much as 39 percent tax on dividends, according to Joel Papernik, partner in the law firm of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, New York. A share buyback, unlike a dividend, lets shareholders choose whether to receive the taxable cash. And companies can cut short buyback programs without being punished, whereas cutting a dividend sets off a wave of bad publicity that lowers the stock price. "You only increase the dividend when you're sure you can afford it year after year. Buying back shares is seen as a safer alternative," observes Keith Black, assistant professor at the Center for Law and Financial Markets, Illinois Institute of Technology, Chicago.
One obstacle that prevented companies in the past from buying back shares forfeiting the use of pooling of interests for merger accounting disappeared June 30, when accounting regulators killed the pooling option. Now finance executives may be more eager to do buybacks, Papernik suggests.
In on the Action
Head NV, a Netherlands-based maker of skis and other athletic equipment, went public last October with a $400 million IPO, then the following month announced a program to buy back up to 10 percent of those shares. The stock price had fallen sharply immediately after the IPO. "We caught the tail end of the market," observes Bob Kosian, head of corporate development. The company used proceeds from the IPO to pay down debt, leaving it with a strong balance sheet, strong but seasonal free cash flow, and an appetite for acquisitions.
"We had told the market we were looking for acquisitions and we are now considering makers of fitness, golf, bicycle and fishing equipment but when we looked at the price/earnings ratios of companies in the sporting goods sector, we saw that one of the best investments we could make was to buy our own shares, so we did," Kosian explains. The shares Head buys back through open-market purchases also offset new shares created when stock options are exercised, he adds.
Miami-based fashion designer Perry Ellis International Inc. has bought back 163,000 shares so far as part of a 500,000-share buyback authorized in July 2000, paying between $4.50 and $9.75 a share, reports Rosemary Trudeau, vice president-finance. "We felt it was the best use of our working capital because the stock was significantly undervalued relative to its book value," she explains. The company also wanted to send a message to investors that it was willing to bet its own money that the stock would appreciate, she adds. Perry Ellis' book value currently is about $13 a share.
"You may buy the shares quietly in the open market over time, but investors know when you make that filing to set up the buyback. They get the message," says James R. Haddad, vice president, corporate finance, at Cadence Design Systems, a San Jose, Calif., electronic design automation business.
While most stock buybacks are plain vanilla and are done by the book, sharp finance executives and investment bankers have come up with some shrewd variations that take advantage of market conditions. Investment bankers, for example, are pitching a plan whereby a company issues convertible debt at the unusually low rates currently available and then uses the proceeds to buy back equity at today's lower prices, reports James R. Haddad, vice president, corporate finance, at Cadence Design Systems, an electronic design automation business in San Jose, Calif. "If the stock appreciates, as you expect, you get back the shares in the future when investors convert, but until then, you've rewarded investors with greater earnings per share by shrinking the number of shares, and you've done so at a very attractive cost," he observes.
Another innovative kind of buyback, pioneered by high-tech companies with volatile stock prices, such as Microsoft Corp. and Dell Computer Corp., uses the options market instead of the stock market and sells puts on a company's stock. "You get cash up front for selling the put," explains Keith Black, assistant professor at the Center for Law and Financial Markets of the Illinois Institute of Technology in Chicago. The company agrees to buy the shares back at a price that's below the market price when the puts are sold. If the stock price goes up, the puts will not be exercised and the company will keep the premium dollars. Only if the stock price falls below the strike price must the business buy back shares. Of course, it has to pay the strike price, even if it's higher than the market price at the time the puts are exercised, so there is some risk involved, he points out.
Still, most companies have not been rushing to announce buyback programs. That's because they are feeling a liquidity crunch, explains Mike Seely, president of Investor Access Corp., an investor relations consulting firm in Stamford, Conn. "They may think their stock is undervalued, but they don't have the luxury to do much about it." Executives must decide whether a buyback is the best use of available cash based on how confident they are that the market has missed something important and that the economy will support their business. Sending a signal is a short-term strategy. But when liquidity is at stake, forget short-term gains and hunker down for the long term, he advises.
Many organizations seem to be doing that. According to Papernik, buyback announcements have declined in recent months. He cites data published by Thomson Financial showing that announcements fell from 1,512 in 1999 to 792 in 2000 and just 179 through May of 2001. "Buybacks are more popular at the beginning of an economic downturn than when we're well into one," he observes.
There are good reasons to be hesitant about a large-scale buyback. The message it sends can be ambiguous; it can signal either management's conviction that the firm has bright prospects for higher share prices in the future or a belief that the company has no promising opportunities in which to invest available cash, notes David Louton, associate professor, finance, at Bryant College in Smithfield, R.I. "Radically different situations can lead to very similar buyback announcements," he observes.
Pharmaceutical giant Merck announced a $10 billion buyback in February of last year, but its stock price continued to fall. "There can be a backlash, especially in fields like high-tech and medical tech, if investors think you don't have enough new product in your pipeline to spend your money on," Papernik observes.
In addition, "while stock buybacks generally are popular among investors, they do sometimes raise negative suspicions," notes Charles Lieberman, managing partner at Advisors Financial Center LLC, an asset management firm in Suffern, N.Y. "Some investors and analysts think managers use buybacks to qualify for more stock options and to enhance the value of the options they hold," he observes. "It's hardly fair to reward managers for boosting value for shareholders and then criticize them for doing precisely that."
A Tale of Two Buybacks
Theory is fine, but two buybacks currently under way suggest that individual circumstances dictate whether and how a business should purchase its own stock.
Trading at just over 2.4 times the company's annual earnings, shares of Nevada Gold and Casinos Inc. were "a great buy for us or anyone else," reports Tom Winn, CEO of the Houston-based resort and casino developer. So the company authorized an open-market buyback of up to 500,000 of its 10.4 million shares. Winn wants to get the price above $3 a share so that the company qualifies for listing on the American Stock Exchange. "We're doing it as a sign of good faith. If we get investor support, we may buy less," he says. Nevada Gold set up a bank credit facility to finance the buyback.
CET Environmental Services Inc., an environmental remediation firm in Englewood, Colo., recently decided to buy back 100,000 of its 6.2 million shares because its stock was trading at around 50 cents, down from a historic high of almost $15. "We know that's not enough to get the market's attention," says Dale W. Bleck, CFO, "so we're doing it largely as an investment. Anything under a buck is a bargain." CET is in the final year of a troubled contract with the federal Environmental Protection Agency to clean up polluted sites. Its revenue dropped from a high of $66 million in 1998 to $25 million last year, with even less expected this year, Bleck explains. "We're practically debt-free, so shrinking equity will reduce our capital base and raise our ratios," he notes. But CET stock trades sporadically, so Bleck can buy back shares only when some come on the market and then, because of SEC regulations, the company can purchase no more than 2,000 shares on any day.
When To Buy Back
The well-timed announcement of a modest buyback program can be a good and relatively safe public relations move, especially when it is implemented cautiously. But a good strategic buyback program should not be a reflexive response to shore up a stock price. It should be driven by a "confluence of circumstances," Lieberman notes. Stock price may be one factor, but the company's cash position and other investment opportunities are also important considerations. In theory, at least, available cash should be used to buy back stock only when that is a company's most productive investment opportunity. "When expanding the business would bring a greater return on investment, then cash should be used for that purpose," he observes.
The right time for a stock buyback depends on why the company wants to do one, says Patrick Finegan, managing director of Finegan & Co., a corporate finance consulting firm based in New York City. He sees three primary reasons behind stock buyback programs:
1. To distribute excess cash to shareholders. Companies throwing off excess cash continue to do buybacks today, pretty much as usual. However, the softer economy means that some businesses have less cash to pass out and that many finance pros will want to increase the size of their cash cushion to ride out a market in which revenue might decline and external capital might be hard to come by, Finegan says.
2. To change the company's capital structure typically to lower its cost of capital by adding debt and reducing equity. Companies also continue to use buybacks for this purpose. If the balance sheet has too much equity and not enough debt, now is a good time to take advantage of low interest rates; equity-heavy companies should be able to borrow cost-effectively and use the money to buy back shares. But finance executives worried about the economy usually seek to lower, not raise, the ratio of debt to equity, so buybacks to change capital structure currently are waning, Finegan says.
3. To signal to the market that executives think the company's stock is undervalued. Market turbulence no doubt has left some companies seriously undervalued, Finegan says. For those companies, "a share repurchase strategy could make a lot of sense," he says. Using a buyback to send a signal of confidence is even more credible when executives increase their own holdings at the same time. When managers sell during an announced buyback, investors suspect that the stock is a bad investment, Finegan notes. "Academic studies have shown that the number one factor that determines the success of a buyback in raising the stock price is whether insiders also are buying for their own accounts," he explains. "When you bet with your own money, people believe you."
Gradually buying back stock on the open market is the most common technique for acquiring small quantities. In this scenario, the organization funds an account with a broker and has the broker buy shares for it whenever it likes the price and has the cash.
For large buybacks, say 10 percent to 25 percent of outstanding stock, a company might use a fixed-price self-tender offer. Finance executives would huddle with investment bankers and pick a price, then follow SEC rules for tender offers. If the offer were oversubscribed, as they often are, investors could sell a percentage of their holdings for example, 12 percent of their shares if 12 percent of all the shares tendered would meet the company's buyback target, Papernik notes.
The type of program an organization attempts should reflect its goals. Buybacks that do not seek to influence the stock price are best done gradually in open-market purchases, Finegan says. "A broker will trickle cash out to the market to retire shares without causing ripples," he explains. A concentrated tender offer is more likely to raise the stock price, he points out.
In a midsize buyback, the company might use a Dutch auction to price the shares it is repurchasing, asking investors to indicate the price at which they would sell a specific number of shares. The company would then take the "clearing" price that would result in hitting its target the lowest price at which enough shares would be tendered and pay investors that amount for their shares, Papernik explains.
Whether a business uses a fixed price or a Dutch auction can make a big difference in what it pays. Studies show that companies generally pay a 15 percent to 20 percent premium over the market price to buy the shares they want under a fixed-price tender, compared with just 8 percent under Dutch auction pricing, Papernik reports. In a Dutch auction, the clearing price usually becomes the aftermarket price, Finegan notes.
Regardless of how a company carries out a buyback, the SEC has an elaborate set of directions that, if followed, provide a safe harbor. For example, section 10b-18 of the Securities and Exchange Act spells out the procedure for an open-market repurchase program it's designed to prevent stock price manipulation, so it prohibits businesses from buying in the first or last half hour of the trading day, buying on an uptick, or buying more than 25 percent of the stock's average trading volume on any one day (for details, see www.law.uc.edu/CCL/34ActRls/rule10b-18.html). "Always follow these safe-harbor rules," attorney Neimeth advises.
Last year the SEC authorized another safe harbor, known as 10b-5-1, which allows a company to continue a highly prescribed buyback program (e.g., buying 100,000 shares the second Tuesday of every month) even when insiders know that an upcoming announcement is likely to cause the stock price to rise, attorney Papernik reports. As long as the program is set up as a 10b-5-1 program and operated without discretion, the company should be safe, he says. The first rule in executing a buyback is to know and follow the rules.
Making It Work
Buying back stock works if you buy enough, professor Black reports. Studies have shown that if a company buys back less than 5 percent of outstanding shares, the impact on share prices is minimal, he notes. But companies that buy back more than 5 percent have outperformed the market, on average, by about 2.3 percent over the following year, he points out. Conversely, companies that increase their outstanding shares by more than 20 percent usually underperform the market in the following year.
Whatever else they may or may not accomplish, stock buybacks remain a surefire way to increase earnings per share. EPS grows whenever you increase earnings or decrease the shares outstanding, Black notes. "A 5 percent decrease in shares gives you a 5 percent gain in EPS just as surely as a 5 percent increase in earnings." Nevertheless, before buying back stock with borrowed money, finance executives must calculate whether they will raise their company's EPS by reducing the number of shares outstanding or lower it by adding to their costs for debt service, Black says.
Buybacks also remain a useful communication tool. Actions speak louder than words and sometimes more discreetly. "Management must walk a fine line, revealing enough of the firm's prospects to convince analysts of its value while withholding enough information to protect competitive advantages," professor Louton points out. "The stock buyback provides credibility without disclosing proprietary information."
But the benefits of buybacks come at a cost, and there are times when executives are wiser not to pay it. "A stock buyback usually is based on confidence," Black observes. "When you're worried about earnings, you hang on to your cash."