Monday, September 28, 2015

Share Repurchases and Agency Costs Revisited

Ralph and I engaged in a debate about the use and abuse of share repurchases here , here and here. I thought it might be useful to revisit the issue as repurchases are on pace to eclipse the pre crisis 2007 record.

First some review. The major motives for share repurchases include:

1)     Reduce Option Dilution: less of an issue once the accounting rules changed and require the expensing of options.
2)     Valuation Signal: useful to close a value gap. Management signifies its belief in future cash flows by return cash to shareholders. Can be strong when debt financed. Usually in response to real or imagined activist threats.
3)     Dividend Alternative: with growth elusive and CAPEX modest free cash flow is building. Firms need to do something with cash piles or face criticism (e.g. Apple and Icahn). Either acquire (M&A is also at a record pace this year) or return the cash thru dividends or repurchases.
4)     Rebalance the Capital Structure: debt financed repurchases are being used to capitalize on cheap debt market conditions. Could achieve the same result using a debt financed special dividend.
5)     Manage EPS (i.e. earn bonuses): hard to increase earnings late in the economic recovery cycle. Thus, incentive to reduce share count via repurchases to achieve EPS target.

Warren Buffett reminds us to repurchase only when the price paid is less than the firm’s intrinsic value; otherwise, remaining shareholders will suffer a value loss. You would expect firms to repurchase shares when their prices are low. The evidence, however, indicates they repurchase when prices are high. This propensity to buy high is consistent with my suspicion repurchases are used to manage EPS, and not because managers are bad market timers. Share prices are also likely to have recovered later in cycle as well (i.e. they are relatively high). Consequently, management is likely to manufacture EPS growth thru repurchases at high prices.

Interesting empirical support for this conjecture is provided by Almeida, et al. They find the probability of repurchases is higher for firms that would have just missed their EPS forecast without the repurchase compared to firms that just beat their forecast. This suggests managers are likely to use repurchases to meet analyst EPS forecasts. Furthermore, they find managers are willing to cut investments in favor of EPS motivated repurchases. It appears late cycle repurchases, just like late cycle M&A, tend to have higher risk of being overpriced. In fact, record repurchases and M&A volumes may suggest the market has peaked (cyclical leading indicators?).

I am all for returning excess cash to shareholders. My concern is over the best method to return the cash-dividends or repurchases. My preference is to keep it simple-use dividends, regular or special, unless management can demonstrate a compelling alternative reason. Taxes may be such a reason. Nonetheless, since most shares are held by institutions this may not as important as you would think. Boards should carefully examine repurchase requests for firms experiencing difficulty in achieving analyst EPS forecasts-there may be an agency cost problem lurking in the request.


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