Monday, January 27, 2014

Share Repurchases 2014

Share Repurchases reached post crisis record levels in 2013. This occurred while the S&P 500 rose over 30% for the year. Thus, it is becoming less likely shares are undervalued. Repurchases are justified, versus alternative distributions like dividends, only when the current share price is below the firm’s intrinsic value, which is based on the capitalized value of management’s forward plan. Consequently, 2014 repurchase volume should decline. My concern is some managers will maintain unjustified over priced repurchases to maintain their bonuses or enhance their stock option values. The focus of this post is on the return of excess cash as dividend substitutes and not debt financed capital structure repurchase alternatives.

Corporate liquidity reflected in excess cash balances continues to rise based on two factors. First, cash earnings improvements based on enhanced productivity continued their post crisis trend. Next, managers have been reluctant to reinvest in growth through either increased CAPEX or M&A. Excess cash should be returned to shareholders to reduce possible agency cost problems. This concern underlies shareholder activists like Carl Icahn’s request to Apple. The question is how that cash should be returned.

The basic choices for the return of excess liquidity include dividends, either special or regular, and share repurchases. As previously discussed Debate Part I and Part II, I have concerns that managers may misuse repurchases. Essentially, rather than invest in risky CAPEX and M&A with a delayed payback, some managers  such as those at IBM may opt for “safer” repurchases to manufacture incentive compensation relation EPS gains.

Cash rich firms with limited reinvestment opportunities should favor dividends over repurchases absent strong evidence that their shares are undervalued. The dividends can either be special or regular depending on management’s future earnings views. If EPS must be raised for some reason it can always be achieved via a reverse split. Tax issues should be second order consideration given institutional ownership at the majority of firms and other means to structure around the issue.

Either use it, return it but do not abuse excess cash by engaging in over priced share repurchases. Directors need to carefully monitor management repurchase recommendation.


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