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.

J

Unincorporating Corporations: The Problem with Large Public Corporate Governance

Large public corporations and their managers have come under increased scrutiny since the great recession. They have taken the easy steps of reducing costs and returning cash to shareholders. Unfortunately, they still face revenue growth problems, excess capacity, changing technology and regulation, and lagging performance. These problems have depressed relative share prices and attracted the interest of third parties. Hostile takeovers bids from strategic acquirers have increased to pre crisis 2007 levels of 20%+ of M&A. Activists like Daniel Loeb’s Third Point have raised record amounts to fund new campaigns to instigate strategic change. Understandably, managers are concerned about this increasingly active market for corporate control. They are reluctant to change formerly successful business models even though conditions have changed due to organizational inertia.

These managers are seeking political support to protect their positions. They allege hostiles and activists with their alleged short term focus harm the long-term value of their firms and ultimately the country. Thus, they evoke stakeholder and long-term holding requirements arguments to slow the process; they just need more time to prove that everything will alright. As Ralph highlighted, allowing alternative stakeholders control over capital supplied by shareholders allows one group to risk the capital supplied by someone else-never a good idea.

Equally unwise is to discriminate against investors based on their holding period. Examples include granting long-term shareholder enhanced voting rights as in France or taxing short term investors at higher rates as proposed by Hillary. When it comes to bearing risk the length of ownership is not a factor. There is no grace period during which new shareholders are shielded from management miscues. The real problem with so-called “short-termism” is poor governance and weak board oversight regarding short term orientated incentive compensation plans. Many public boards have been “captured” by management.

The agency cost problem with large slow growth public firms was pointed out over 25 years ago by Michael Jensen in his seminal article. The eclipse is a work in process. Attempts to inhibit the market for corporate control will retard reform efforts. It is puzzling that we do not see more going private transactions for large public low growth firms (like Buffett-3G Heinz and Kraft acquisitions) if markets are so short term. This is especially compelling since they no longer need public capital market access to fund their limited growth opportunities

An interesting legal development is taking place which may offer some new solutions to the agency cost-governance breakdown. The development is outlined in a recent book. Business form matters because it impacts governance and agency costs. The statutory based corporate form may be inefficient for mature public firms. Contract based limited life alternatives like limited liability companies (LLC), REITS and limited partnership do away with permanent capital and encourage the disgorgement of cash. They require investors to “re-up” in new vehicles if they believe in management.

The problem of failed attempts to adjust to a volatile business environment (Schumpeter's Ghosts) is highlighted in a provocative new BCG report. The life expectancy of domestic public firms has declined by almost 50% over the past 30 years due to bankruptcy, liquidation, M&A, LBO, or other causes.  The 5 year morality rate or exit risk for for U.S. public firms is now over 30% compared to just 5% on the 1960s.

There is no escaping change. Not everyone can or will adjust. The agency problem in public firms complicates the problem. The market for corporate control and evolving legal structures are some market solutions addressing the problem. They are preferred over political “solutions”, which merely try to hold back change.

J

Finance Debt Fetish?

The go-to recommendation from many consultants and academics is to lever up your firm to increase your tax shield, lower your WACC and fend off activists. This approach may fit for some mature firms. It is, however, less well suited for other firms.

A useful approach to setting debt policy as reflected in a firm’s actual or implied debt rating is based on a firm’s life cycle. Consider the following:

1)     Early and growth stage firms: most of their value is reflected in growth opportunities from assets not yet in place. They have negative free cash flow due to operating losses, high business risk and high CAPEX. Hence they need flexibility to complete their investment plan and maintain access to capital. Such firms have high financial distress costs. Furthermore, they have limited taxable income i.e. tax shields have limited value. Such firms should and do have low debt levels.

2)     Mature firms: generate more cash than they can profitably invest due to high operating income and reduced investment needs. Business risk has decreased and the need for financial flexibility is low as is business risk. Additionally, they have high taxable income in need of tax shields. Finally, agency/incentive issues become prominent regarding investment allocations. In these circumstances, increasing debt makes sense. Witness the “old” tech firms like Apple that have pressured by activist to increase debt level to reduce the risk of misallocated capital. Also confirmed by consumer non durable firms which spend time on tax planning, including use of debt related tax shields, to reduce their tax burden.

3)     Declining firms: here the emphasis shifts from value creation and taxes to value transfers among the firm’s various claimants. Debt holders, often purchasing the debt in the secondary market at a discount, are looking to squeeze-out shareholders and gain control of the firm’s assets in a disguised bargain purchase. Equity holders are seeking to protect their interests. The Caesar’s Palace’s bankruptcy has highlighted questionable transfers by PE firm Apollo to shield assets from creditors.

In addition to life cycle and taxes there are other reasons firms may favor debt. These include:

1)     Information asymmetry discount (AKA Pecking Order Theory ): debt is a contractual obligation v equity which is a residual claim. Hence, there is more informational uncertainty regarding equity, and equity investors require a higher discount to induce them to commit. Managers recognize this fact and exhaust internal funds and debt capacity before issuing additional equity.

2)     Ownership/Control: maintaining ownership and control (ownership v earnings dilution) is very important for private and smaller closely held public firms. Thus, equity is not a preferred funding instrument.

3)     Discipline: agency issues arise whenever management’s interests diverge from shareholders. Debt can provide the discipline needed to hold management’s feet to the fire. This is a driving force behind many LBOs (agency costs).

4)     Signaling: issuing equity for mature firms usually results in a stock price decline. Investors view the raise as a signal that future cash flows will be less than expected. Debt must be serviced (P&I). Management would not issue equity if they thought it was undervalued.  Conversely, management would not issue the debt unless it thought the firm could repay it.  Consequently, debt issues are viewed by investors as neutral.

5)     Value Transfers: see the declining firm discussion above. Creditors attempt to protect against this include seniority, security and covenants. Legal protections include substantive consolidation, fraudulent conveyance and equitable subordination.

The above framework can aid managers seeking to make capital structure decisions.

j

The Jos A Bank- Men’s Warehouse-Eddie Bauer: Poison Pill or Suicide?

Ralph has discussed the agency Problem whereby management acts in its own self interest against the best wishes of shareholders. The current Joseph A Bank -Men's Warehouse- Eddie Bauer ménage a trios provides a vivid example of managers acting badly. The sequence of events is as follows:

1)  October, 2013: Bank offers to acquire its larger competitor Men

2)  November, 2013: Men proposes to acquire Bank for $57.50 per share

3)  December, 2013: Bank rejects Men’s offer

4)  January, 2014: Men begins a hostile takeover of Bank offering $57.50 per share-about a 40% premium to Bank’s pre October price

5)   February, 2014: Bank makes a combined offer to acquire Eddie in a combination cash-stock deal worth $825mln. The $300mln stock portion values the shares at $56 per share. It also offers to repurchase $300mln of its shares at $65 per share. The new offer represents a 52 % premium over Bank pre October price.

6)   February, 2014: Eminence Capital, 4.9% Bank shareholder, objects to Bank’s actions threatening a proxy battle and legal action.

7)   February, 2014: Men revises its offer to $63.50 per share with a further increase to $65 if it is allowed due diligence. The revised offer is conditioned on Bank terminating the Eddie offer. Men offers to cover the Eddie breakup fee up to $48mln. Eminence supports the revised offer.

Both Bank and Men agree the combination makes sense in the slow growth men’s apparel industry. The only issue is which management team survives to run the combined firm.

Bank decided to make itself so ugly that its unwanted suitor would lose interest and their jobs would be safe-shareholders be damned. Here is what they did and it is pretty ugly:

1)  Purchase Price multiple (PPX): They offered a 14X trailing EBITDA for an ill fitting Eddie that had earlier been bought out of bankruptcy by Golden Gate Capital. The going retail PPX is around 8X.

2)  Funding: The share portion of the consideration leaves Gate as Bank’s largest shareholder at around 17%. Bank is borrowing $900mln-$400mln bridge loan and $500mln ABL-arranged by Goldman who is also Bank’s advisor. This will leave Bank in a leveraged state with reduced flexibility.

3)  Share Repurchase: The repurchase is justified as reducing the dilution from the share portion of the consideration. What is especially interesting is they are issuing shares at $56 per share while repurchasing shares at $65. Selling shareholder will benefit at the expense of the remaining shareholders.

This is almost like giving yourself VD to scare off an unwanted lover-the ultimate poison pill I guess. Nonetheless, I would hope there would be less painful alternatives.

The end result is a blatant case of management agency costs at work. Bank management not only failed to capitalize on a favorable buyout offer-made even more favorable by the revised Men offer. They are also attempting an overpriced acquisition with limited synergy potential, which would leave the Bank in a weakened financial state. Just when you thought it could not get any worse, they decided to make an overpriced share repurchase. They should get an award for attempting the shareholder value destruction trifecta. Oh well, what do they care-if they get to keep their jobs. Hopefully, for Bank shareholders, the new Men offer will save them from such actions.

J