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

Something is happening here-what it is ain’t exactly clear…

(Buffalo Springfield-For What It’s Worth- 1966)

Another question raised at the Amsterdam Acquisition Finance course concerned the persistent muted level of M&A activity. Global 2013 M&A volume, despite a promising start, remains depressed at near 4 year lows.  U.S. volume is up 6% largely driven by the $124B Vodafone-Verizon transaction. Europe had its worst year since 2009. The U.K. market is at its lowest level in over a decade. This is surprising given the following ordinarily supportive factors: 

1)     Rising corporate cash balances and cash flow.

2)     Record private equity (PE) dry power and fund raising. PE firms have over $800B to invest of which $140B expires by YE 2014.

3)     Favorable financing environment.

4)     Positive shareholder responses to recent acquisition announcements.

5)     Limited organic growth opportunities and substantial industrial excess capacity.

6)     Robust stock market with strong buyer stock price performance-the S&P 500 is up over 22% thru early December this year and is trading at record levels.

The possible rationales for this puzzling state of events include:

1)     Buyers lack confidence to make substantial long term commitments due to their uncertainty about the economic recovery and our dysfunctional national government. This becomes less convincing given the steadily improving news about both the economy and the government.

2)     The substantial stock market recovery makes it difficult to find attractively priced targets. This makes some sense, and is reflected in current low premiums being offered. Usually, premiums over the pre-bid price are in the 30% range, whereas currently they are just under 20%. Given the 20%+ recent price increase for targets the effective premium could be viewed as closer to 40%.

3)     Stock repurchases rather than acquisitions have become the preferred corporate finance alternative for many firms. For the LTM stock repurchases have reached almost $450B-the highest level since 2008. Some of this is being driven by activists pressuring firms with bloated cash balances like Apple to use or return the cash.

As previously noted (see Repurchases) I believe stock repurchases are frequently misused. As Warren Buffett notes (see Price Matters) they should only be used if the firm’s stock price is priced below its conservatively determined intrinsic value. The current record stock price level makes it difficult to believe many firms are under priced. Thus, if they want to return excess cash to shareholders they should increase their dividend payout or declare a special dividend. Possible tax benefits of repurchases are probably a secondary consideration given the institutional ownership of most shares. To be fair, some firms like 3M, are using a combination of repurchases and a dividend increase (see 3M).

Many firms may be deferring acquisitions in favor of repurchases for incentive compensations purposes. A successful acquisition typically takes a few years before having positive earnings per share (EPS) impact. A repurchase, however, has an immediate positive EPS impact due to the immediate decline in outstanding shares. This is important as many senior management incentive programs are tied to EPS growth. Managers lacking confidence in EPS growth from acquisitions relative to repurchases will favor repurchases over acquisitions.

 This could be the reason for the depressed level of M&A activity. Researchers like Ralph will need to determine whether this is in fact the case. Perhaps they can see if firms with incentive programs tied to EPS growth are less likely to acquire. I welcome any comments you may have in helping resolve this open question.

Thanks, and I wish you all Happy Holidays.

j