There are many theories explaining the pros and cons of share repurchase.  Joe and I have debated many of these points in a series of four posts (to see the links to all of these see Repurchases: Part 4 - Some Concluding Comments).  One theory is that share repurchases signal positive information.  Another theory suggests repurchases transfer wealth from bondholders to shareholders because repurchases erode the equity base and increase risk to debt.  

Previous research is generally supportive of positive signaling but inconclusive with regard to wealth transfer.  Part of the problem with testing the wealth transfer hypothesis is that all bond repurchases are not alike.   In a very interesting article Kathy Kahle notes that the purpose of many share repurchases is to support executive options and that it is important to disentangle these effects when testing various hypotheses. (See When a Buyback Isn't a Buyback.) We utilize this result in a more refined test of the signaling and wealth transfer hypotheses that was published in the Journal of Corporate Finance in 2009.  The abstract and download information is below.

Share Repurchase, Executive Options and Wealth Changes to Stockholders and Bondholders

Sang-Gyung Jun 
Hanyang University 
Mookwon Jung  Kookmin University 
Ralph A. Walkling  Drexel University - Lebow College of Business 

We test the signaling and wealth transfer hypotheses around the announcement of share repurchases using a recent and larger sample of data than previously examined while employing a methodology designed to enhance the power of our tests. Disentangling the wealth transfer and signaling hypotheses is difficult; they are not mutually exclusive and can have opposite effects for bondholders. Wealth transfers will decrease bondholder wealth while positive signals will increase it; the combined effects obscure tests of each hypothesis. By focusing on sub-samples where signaling is more and less likely to be present we increase our ability to isolate the separate effects. In addition to traditional tests of wealth effects, we feature information inherent in the relation of wealth changes to equity and debt. Also, it is important to examine more recent evidence surrounding repurchases, particularly for bondholders. Most work on wealth changes to bondholders ends in 1997 with the demise with the Lehman Brothers Bond Database. Our results are generally consistent with the positive signaling effect of stock repurchases, but also provide some support for wealth transfer. Our work also emphasizes the importance of trying to disentangle the various hypotheses. In the subset of option funding repurchases, where signaling effects are less likely, the positive correlation of wealth changes between stockholders and bondholders is completely eliminated. Bond ratings are much more likely to be upgraded in samples without executive options which is precisely where the signaling effects are expected to be concentrated. Governance factors are insignificant.

Click here to find the final version of the article  or here to download a free, slightly earlier version.

All the best,

Ralph

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

Increase Bank Dividends? Not So Fast

In a recent article published in the American Banker, I take a skeptical view of the practice of many banks that are currently seeking to return capital to shareholders via dividends and share repurchases.  

Although it was unthinkable a few years ago, some bankers and pundits believe banks have excess capital that should be returned to shareholders through dividends and stock repurchases. Banks have rebuilt capital positions from their depressed crisis levels largely through improved earnings from reduced credit costs. Lackluster returns on equity, limited investment opportunities and crisis-related curtailed payouts have raised the call for the return of perceived excess capital to improve ROE. ..... "   See the complete article at:  American Banker

J 

The Dell Stock Repurchases Program - Hmmmmmmmmmmm

Ralph and I have an on-going debate on the merits (Ralph) and demerits (me) of share repurchases. My point is not all repurchases are the same. Some may be value enhancing. Others, however, are not. They can be used by executives to manipulate earnings per share (EPS) to improve their option values.

Floyd Norris' January 18,2013 New York Times article on the misuse of repurchases at Dell provides a cautionary tale for shareholders. He analyzed Dell's long running approximately $ 40 B program. He concludes over priced repurchases benefited corporate executives at the expense of long term shareholders. Michael Dell, Dell’s founder and largest shareholder, was a substantial option recipient. His gain is estimated at over $650 MM. Executives would profit if Dell stock price increased following a decline in the number of outstanding shares post repurchase compared to a dividend. This encouraged repurchases to offset potential stock price weakening by increasing EPS as operations began to mature. This occurred despite the negative impact on long-term non-tendering shareholders. This occurred because the repurchases, being over priced, transferred value from remaining shareholders to those tendering. Michael Dell's losses were offset by his option gains, which were unavailable to non-executive shareholders, plus the gain on any shares he tendered. Dell paid an average repurchase price over the years of $ 19 per share compared to the current price of $ 12. A general observation is firms facing a challenging operating environment who have stock option programs may be prone to questionable repurchases.

The current low share price due to concerns over the firm's business model has increased the interest in taking Dell private. Michael Dell is rumored to contribute his shares into the potential LBO. This raises conflict issues as to who he represents-the firm's shareholders or himself in the buyout negotiations. Given his record on the repurchase program we can only guess hmmmmmmmm.

I promise this will be the last post on repurchases for a while. There will be more posts on Dell as the story develops.

j

Repurchases Part 4: Some Concluding Remarks

In three previous posts Repurchases: Part 1 Shareholders Beware and Repurchases Part 2: The Positive Side,  and Repurchases, Part 3: Joe Responds, Joe and I have debated the merits of repurchases.  Today's blog contains Part 4 where we continue the debate and try to summarize.  

Thanks to all for your comments.  You are also welcome to post them here.

Joe and Ralph

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Ralph:

Joe, your Repurchases Part 3 contains some great comments.  Maybe I'm being picky but I still kinda disagree with two points.  

First,  and this is technical, share repurchases can alter the capital structure and as they increase leverage, the tax shield increases.  This can create value if it doesn't increase risk excessively.   For many repurchases, this can be a minor effect.  However, a company can increase its leverage quickly by borrowing and using the proceeds to repurchase stock.

Also, while I agree you can replicate repurchases with special dividends, your shareholders will suffer much higher taxes.

Joe:

Yes, but you can get same leverage impact thru debt financed special dividend.

Regarding taxes - it depends on the shareholder base-clientele.

Ralph:

OK, I agree you can get the same leverage impact, good point, but still think either approach can create value.  It might be that we disagree whether leverage can 'create' value.

On taxes, yes, but capital gains  are taxed at a substantially lower rate than ordinary income (dividends).

Joe:

Taxes are not an issue for investors like untaxed pension funds

Microsoft’s 2004 32B special dividend is counterfactual.  If the tax

disadvantage is key,  then why didn't they use a repurchase?

Ralph:

I agree with your comments about untaxed pension funds - and institutional ownership is quite high in corporate America.  To other investors it would matter.

Regarding Microsoft, I don't know the answer.  I do note that in addition to the special dividend, they also repurchased shares.  So they actually did both.  As far as I know, Steve Ballmer and Bill Gates do pay taxes, so the mystery remains.  (Bill Gates was reported to donate the proceeds he received to his charity but I still think repurchases would have saved taxes.)

I do think we can agree that:

Share repurchases can be controversial!  And, while they offer tax advantages over dividends, they can be abused.  Two possibilities for this abuse are a) the apparent, but misleading, increase of earnings through repurchases and b) companies that overpay in repurchases harm existing shareholders. 

Dividends don’t produce the overpayment problem, but force shareholders to accept the distribution, while repurchases give them the option to defer.

Also, since it is difficult to precisely estimate the value of one’s shares, companies should proceed cautiously with repurchases. 

Finally, companies that cannot put cash to use at rates higher than those demanded by shareholders should return it in some form.  If you increase regular dividends make sure they can be sustained.  Otherwise, consider share repurchases and special dividends.

Repurchases, Part 3: Joe responds

In two previous posts Repurchases: Part 1 Shareholders Beware and Repurchases Part 2: The Positive Side, Joe and I have debated the merits of repurchases.  Today's blog contains Part 3, Joe's response.  We'll conclude (maybe) our current discussion on repurchases on Wednesday.  We'll both respond to these points and try to summarize.

R

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Joe:

Perhaps, I was overly critical of share repurchases in my previous post. Ralph raised several good points to which I would like to offer some clarifying comments.

1) Shareholder distributions, dividends and repurchases, do not increase value since they do not affect firm cash flows. They are, however, correlated with value changes.

2) Not all repurchases are created the same. Their impact depends on their size, premium offered, execution method, and funding. Small, excess cash funded, low premium open market repurchases are associated with small effects.

3) Everything that can be done with a repurchase can be done with a combination special dividend and reverse split. My point is to understand what is driving management's choice of a repurchase over a dividend, and whether it serves the best interests of continuing shareholders. A possible motivation  may be that while most stock option plans adjust for repurchases, they do not adjust for dividends. Thus, stock options are worth more to executives when cash is returned through repurchases v dividends. Interestingly, Berkshire Hathaway, which recently announced a repurchase, does not grant large levels of options and restricted shares to its executives thereby avoiding this issue.

4) The danger of a value transfer from continuing to selling shareholders exists when management overpays relative to the stock's intrinsic value for the repurchase. Berkshire provides an excellent example of pricing discipline in its repurchase policy. They state repurchases will be approved only to return excess cash when its shares are trading for less than 120% of their net asset value,  i.e. intrinsic value.

Bottom line, trust, but verify. Repurchases are more complex than they first appear. The FT's 1/2/13  Lex Column put it best: "Companies should manage cash carefully so a payout is sustainable across the cycle. Failing that, special dividends work just fine, thanks. Cash that a company earns that cannot be invested for adequate returns belongs to shareholders. Keep it simple, and return it to them.".

J

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