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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