Share Repurchases: Part 1 Shareholders Beware

Happy 2013 to All!

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A strength of our blog is the combined and sometimes differing viewpoints on topics.  Today, Joe warns of the dangers of repurchases.  On Monday, I'll talk about some positive elements of repurchases.

Ralph

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Slow organic growth and a tepid M&A environment have caused an embarrassment of riches at many firms with increasing capital and cash levels. Managers are concerned about falling ROEs , stagnant earnings per share (EPS) and their incentive compensations plans which are tied to those measures. Shareholders are also expressing concern over raising capital levels. Their concern is it may be reinvested in over- priced acquisitions among other things. Thus, they are putting pressure on management to return excess capital. This in turn raises the question of how best to return capital. The focus of this post is on excess cash funded repurchases-not debt financed repurchases -which involve capital structure considerations.

Share repurchases, aside from technical tax differences depending on the tax status of the firm’s investor clientele, have similarities with dividends as a cash distribution mechanism. For example, a dividend combined with a reverse stock split yields the same result as share repurchase of the same amount. Dividends and repurchases differ, however, in certain important respects. For example, EPS will be higher with a repurchase compared with a dividend absent a reverse split because of a reduced number of shares. This is true even though the ROE is same under both distribution alternatives. Thus, repurchases can be used to disguise poor earnings growth through manufactured EPS growth by reducing the denominator of the calculation instead of improving the numerator.

Another difference concerns the allocation of value between the selling and remaining shareholders. All shareholders receive dividends. Only the selling shareholders receive cash in a share repurchase. Remaining shareholders are penalized when shares are repurchased at a price above their intrinsic value. In that case value is transferred from the remaining shareholders to the selling shareholders. Managing this risk is difficult as it can only be assessed after the fact. Historically firms are poor at timing share repurchases at the appropriate price-i.e. they overpay.

A simple discount to a target is insufficient to justify a repurchase.  The discount may be warranted due to poor earnings prospects. Management over-optimism frequently results in over-paying departing shareholders at the expense of those who remain.  Particular attention is needed to guard against repurchases that are overpriced to influence stock prices by increasing EPS. Managers seeking to game incentive compensation systems tied to these measures will propose repurchases. EPS improvements following a repurchase are, however, offset by falling price-to-earnings ratio without necessarily increasing long term value. Repurchases affect the distribution of value, not the creation of value as operating results remaining unchanged.

Boards reviewing a repurchase proposal should follow a three-step process. First, they need to understand and approve the motive for the repurchase. Motives other than the efficient return of excess cash should be challenged. Next directors must understand the firm’s conservatively calculated intrinsic value. They should approve stock repurchases only below that value. Thus, managers should justify repurchase prices based on credible intrinsic value estimates.

Boards should be skeptical of managerial undervaluation claims. This may reflect a poor investor communications that should correct over time. Alternatively, investors may not believe management value estimates. When in doubt a special dividend may be better than a potentially overpriced repurchase. Finally, the distribution should be part of an overall capital plan that is tested under adverse macroeconomic scenarios.

The repurchase decision involves complex valuation and governance considerations. Investors are not and should not be indifferent to these factors. This requires clear thinking by the board to protect the interests of non-selling shareholders against potentially conflicting management motivations. Capital management assumes Uheightened importance in a low growth environment. This includes selecting the best means to return capital to shareholders when it cannot be profitably reinvested in organic or acquisition opportunities. Repurchases are not necessarily bad, but when misused they can reduce shareholder value. So, shareholders beware.

Joe