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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Value is Estimated, Price is Paid

Today's blog continues our more detailed analysis of each of the 14 Keys to Acquisition Success.  We are at Point 10.

10.  Value does not equal price.   As our friend Bob Bruner has noted, Price is what you pay, Value is what you estimate.

This one is simple.  And fundamental to success.  And often overlooked.When anticipating a deal, we estimate value.  It is an imprecise science involving discounted cash flow, price multiples, and comparables.  Each estimate requires judgement and our projection about the future.  True value is unknown and only realized with time.

This is, of course, at the core of business enterprise: risk and return.  Risk is inherent in business decisions - it is at the heart of opportunity.  But we need to be compensated adequately for the risks we take.  And the crucial, immediate key to that compensation is in the price we pay at the very beginning of a deal.

If the payment is in cash and doesn't involve earnouts or other contingent payouts, the price we pay is known, and even if payment is in stock or other securities, they can generally be converted to cash.  So a known price is paid in exchange for uncertain value.  There is no better or easier time to create or destroy value than when bidding for a potential target.   

The moral of the story is to be careful, very careful about estimating value.  It is easy to make mistakes.  To repeat: there is no better (easier) time to create (destroy) value than when setting the price.  Tread carefully. 

Joe's recent blog about the HP - Autonomy  deal noted is a good example: "The Autonomy deal - priced at 11X revenues, 24X EBITDA, 3X assets, and a 60%+ pre-bid stock price premium - was DOA at close."  Even without misrepresentations it would be hard to recover from such a rich payment.

Ralph

Repurchases: Part 2 The Positive Side

On our last post, Repurchases: Part 1 Shareholders Beware Joe pointed out some concerns about repurchases.  These are good cautions, but I'm an empiricist and I need to point out that the empirical evidence on repurchases is much more positive.  In the paragraphs below,  I'll first outline some theories about share repurchase and then discuss some empirical evidence.  

We generally assume one of six things is going on with a share repurchase.  First, a firm could feel that its stock is undervalued and the repurchase signals positive news to the market about this inside view.  In this case, we'd expect to see the stock price rise on the announcement of a repurchase.  Second, the firm could use repurchases as an efficient tax-advantaged way to return excess cash to shareholders.  It is efficient and tax advantaged since capital gains are taxed at a lower rate than dividends.  Third, the repurchase signals that management is not going to squander excess cash on things like unproductive acquisitions.  Both of these are positive effects and the stock price should rise upon announcement of a repurchase.  Fourth, an in contrast to the previous item the repurchase could signal a lack of growth opportunities for the firm.  In this case, we'd expect the stock price to decline at the announcement of a repurchase.  Fifth, since repurchases reduce the equity position in a firm, they change the capital structure producing less cushion for debt holders.  If true, debt holders would lose upon announcement of a repurchase; equity holders would gain.  Sixth, firms sometimes repurchase shares to fund executive options. One can imagine other motives, some of which Joe outlined in his post.  I'll return to that in a moment.  

The empirical evidence on repurchases is strongly consistent with a positive impact to shareholders and generally supportive of the first three hypotheses mentioned above: signaling, tax efficiency, and the return  (rather than squandering)  of excess cash.  The fourth and fifth hypotheses ( a lack of growth opportunities and wealth transfers from bondholders)  find less support.  On the sixth hypothesis, Kahle (2002) also provides compelling evidence on the use of repurchases to fund executive options.  This is not, by itself detrimental, but has clouded some empirical tests of the other hypotheses.  (For an elaboration on this see Share Repurchases see our article in the Journal of Corporate Finance, Share Repurchases Executive Options and Wealth Changes to Stockholders and Bondholders.) 

So the empirical evidence is overwhelmingly positive and I find myself more optimistic about repurchases than Joe.  This does not mean that shareholders shouldn't be concerned with the cautions that Joe notes.   The empirical results we discuss in this post are statistically significant tendencies.  Individual firms could still be using repurchases for less than desirable reasons.  Indeed, some of the items Joe notes (use of repurchases to mechanically raise earnings per share, for example), have no empirical justification.  Concerns about firms overpaying shareholders who tender make sense.    Other items like repurchases to alter option values suggest fruitful additional ideas for additional analysis.    These things may exist in a subset of the data.  The wise investor or board member can take comfort from the positive evidence about repurchases, but should sprinkle this with healthy skepticism for possible abuse.  

Ralph

Share Repurchases: Part 1 Shareholders Beware

Happy 2013 to All!

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A strength of our blog is the combined and sometimes differing viewpoints on topics.  Today, Joe warns of the dangers of repurchases.  On Monday, I'll talk about some positive elements of repurchases.

Ralph

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Slow organic growth and a tepid M&A environment have caused an embarrassment of riches at many firms with increasing capital and cash levels. Managers are concerned about falling ROEs , stagnant earnings per share (EPS) and their incentive compensations plans which are tied to those measures. Shareholders are also expressing concern over raising capital levels. Their concern is it may be reinvested in over- priced acquisitions among other things. Thus, they are putting pressure on management to return excess capital. This in turn raises the question of how best to return capital. The focus of this post is on excess cash funded repurchases-not debt financed repurchases -which involve capital structure considerations.

Share repurchases, aside from technical tax differences depending on the tax status of the firm’s investor clientele, have similarities with dividends as a cash distribution mechanism. For example, a dividend combined with a reverse stock split yields the same result as share repurchase of the same amount. Dividends and repurchases differ, however, in certain important respects. For example, EPS will be higher with a repurchase compared with a dividend absent a reverse split because of a reduced number of shares. This is true even though the ROE is same under both distribution alternatives. Thus, repurchases can be used to disguise poor earnings growth through manufactured EPS growth by reducing the denominator of the calculation instead of improving the numerator.

Another difference concerns the allocation of value between the selling and remaining shareholders. All shareholders receive dividends. Only the selling shareholders receive cash in a share repurchase. Remaining shareholders are penalized when shares are repurchased at a price above their intrinsic value. In that case value is transferred from the remaining shareholders to the selling shareholders. Managing this risk is difficult as it can only be assessed after the fact. Historically firms are poor at timing share repurchases at the appropriate price-i.e. they overpay.

A simple discount to a target is insufficient to justify a repurchase.  The discount may be warranted due to poor earnings prospects. Management over-optimism frequently results in over-paying departing shareholders at the expense of those who remain.  Particular attention is needed to guard against repurchases that are overpriced to influence stock prices by increasing EPS. Managers seeking to game incentive compensation systems tied to these measures will propose repurchases. EPS improvements following a repurchase are, however, offset by falling price-to-earnings ratio without necessarily increasing long term value. Repurchases affect the distribution of value, not the creation of value as operating results remaining unchanged.

Boards reviewing a repurchase proposal should follow a three-step process. First, they need to understand and approve the motive for the repurchase. Motives other than the efficient return of excess cash should be challenged. Next directors must understand the firm’s conservatively calculated intrinsic value. They should approve stock repurchases only below that value. Thus, managers should justify repurchase prices based on credible intrinsic value estimates.

Boards should be skeptical of managerial undervaluation claims. This may reflect a poor investor communications that should correct over time. Alternatively, investors may not believe management value estimates. When in doubt a special dividend may be better than a potentially overpriced repurchase. Finally, the distribution should be part of an overall capital plan that is tested under adverse macroeconomic scenarios.

The repurchase decision involves complex valuation and governance considerations. Investors are not and should not be indifferent to these factors. This requires clear thinking by the board to protect the interests of non-selling shareholders against potentially conflicting management motivations. Capital management assumes Uheightened importance in a low growth environment. This includes selecting the best means to return capital to shareholders when it cannot be profitably reinvested in organic or acquisition opportunities. Repurchases are not necessarily bad, but when misused they can reduce shareholder value. So, shareholders beware.

Joe

Back to the Future Again: The Beginning of a New Debt Bubble?

You cannot blame investors reaching for yield given the current near zero interest rate environment. This has depressed credit spreads and increased the market appetite for higher risk transactions. Plentiful cheap credit has proved to be too much of a temptation for many firms to ignore.  An unintended consequence of this development has been an increase in corporate leverage for both investment grade and noninvestment grade corporate issuers. Much of this increase for investment grade firms is related to shareholder distributions such as debt financed dividends and share repurchases.  Issuers like Costco and others have been issuing new debt to fund these distributions. True, some of this is related to the expected increase 2013 tax changes. Nonetheless,  the net result is investment grade corporate leverage multiples are creeping up to 2X EBITDA.  Just like in the pre-crisis era, firms are scolded for lazy balance sheets with low debt levels and high cash balances. The rise in leverage levels for the noninvestment grade LBO is even more dramatic. Leverage as a multiple of EBITDA has increased to over 5.5X while equity levels have fallen below 35%. These levels are approaching their pre-crisis highpoints.

This is reminiscent of the 'optimizing balance sheets by leveraging up' themes prior to the crisis. The problem with leverage is the benefits are visible while the costs are hidden. This is because risk is difficult to measure. The key benefits are control, usually reflect in share accretion, taxes (because interest expense is tax deductible) and higher equity returns. The tax benefit associated with leverage comes from a value transfer from the IRS by reducing their take in the firm’s cash flows. This benefit was reexamined and revised  downward from the statutory tax rate times the level of debt by Merton Miller in 1977 once the impact of personal taxes are considered.

Leverage costs are reflected by the product of the probability of distress times the cost of distress. The probability of distress is a combination of business risk from factors including cyclicality, regulation, competitors , and others as outline in my previous  November 14, 2012 post "How Much Debt is Right for Your Deal?".  The second component-cost in the event of distress -is much more amorphous and frequently understated if not ignored all together. These included heighten risk of competitor attacks, negative relationship impact on suppliers, customers and employees, and ultimately risk of default and failure. Leveraged firms have simply less room for error. Many firms discovered this fact during the 2008/2009 period.

These firms lost financial market access, were unable to rollover maturing debt, had to curtail investments and dividends, and some ultimately failed. As James Grant has noted all lessons in finance are cyclical and not cumulative. They are continually being rediscovered. What is surprising is how quickly many of the crisis lessons have been forgotten again. They may be painfully rediscovered again.

Financial markets still face considerable macro headwinds which could result in their closure to some firms. This could severely impact their strategic investment programs - their main source of shareholder wealth creation - and especially the flexibility to capitalize on market disorder by profiting from competitor weakness. That is why capital structure decisions must be tied to overall strategy. Also, they must be consistent with an appropriate debt rating and liquidity levels.

Less leverage and more liquidity are not mere redundancies or insurance. Rather, they represent opportunistic investments. Firms sometimes under estimate their liquidity and capital needs during bullish markets. Apart from tax shields (which may be overstated) leverage does not create value-it only magnifies short term results.  In addition, offsetting costs of financial distress are difficult to estimate. See Nassim Taleb’s recent book “Antifragile -Things That Gain from Disorder” (Random House, 2012) for a more philosophical approach to this topic.

Cautious Joe

p.s. Best Buy (original post November 19, 2012 “Not Sold on Best Buy LBO") update: The firm has granted its largest shareholder and founder an extension to next February to make a bid. This another sign of the difficulties associated with the planned buyout. As the saying goes, good deals get done right away, while bad deals don’t.


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We won't post next week, but will return Jan 4.  We wish all of you a wonderful holiday season and a fantastic 2013!

Joe and Ralph

Speculation Spreads and the Market Pricing of Proposed Acquisitions: Part I

A useful tool in merger analysis is what we have termed the Speculation Spread.  Simply put, it is the percentage difference between an announced bid price and the current market price of a stock.

Speculation Spread = (BP - P1)/P1

where BP is the bid price offered for a target and P1 is the price at some point after the announcement, say one day later.  Let's take a simple example:  Consider a stock trading at 20 euros.  There is a surprise announcement by a bidder offering 30 euros in a deal to be completed in a month (if all goes well).  What happens to the stock price the day after the announcement (or more likely 30 seconds after announcement )?  Typically the stock price would move to 29, 29.50, or even 29.80.  Thus, the Speculation Spread is either 3.4%, 1.7% or 0.7%.  This is the return you would earn if you purchased the stock the day after the announcement and it was completed as announced, without revision in the price.  Your actual return would depend on price revisions, whether the deal was completed and, if you are concerned about the time value of your investment, how long it took to complete the deal.  For example, if the stock price is revised upward by the current bidder or another bidder, your gains would be greater.  (Interestingly, bids are occasionally revised down as well.)  If the deal falls through, your returns would depend on the post deal stock price.  If you add holding costs in the equation, deals that take longer to complete reduce your return.

Some simple examples are illustrative.  First, rule out any possibility of bid revision.  In that hypothetical world movements of the post-announcement price to 25, 27, or 30 euros indicate the probability of deal completion at 50%, 70%, or 100%.  Thus, the market is predicting the probability of deal success.

Jan Jindra and I analyzed these topics in a paper published nearly a decade ago in the Journal of Corporate Finance. A version of the paper can be found at Speculation Spreads and the Market Pricing of Proposed Acquisitions.

In about a fifth of the cash tender offers we analyzed, the price after the announcement exceeded the bid price!  For example, suppose the market price goes to 31 euros after the announcement.  This represents a Speculation Spread of  negative 3.2%.  Why would this occur?  Obviously, the market thinks the deal will be revised to a higher price.

In our analysis, we tested for the information actually contained in the Speculation Spread.  Our results indicated that the market prices not only the probability of completion, but the probability of deal revision and the length of time until offer completion.  Thus, a great deal of information is contained in the Speculation Spread.

Moveover, the  movement of the Speculation Spread over the course of a deal is very informative about the prospects of the deal.  More of that in Part II.  For now, we note that in recent news, the Canadian miner, First Quantum Minerals, LTD. has made a hostile bid for Inmet Mining Corp.  The offer is for C$72 per share or about $73 US.  (The offer is 50% in stock which complicates the analysis a bit.)  The original offer was in October for C$62 per share although it apparently wasn't announced publicly.  Consistent with this, the stock price didn't close above C$60 until the week of November 26.  It is currently trading at US $73.83 off just a bit from its previous close of us $74.11.

After our paper was published, someone became enamored of the potential risk arbitrage opportunities and contacted me about setting up a hedge fund.  Another person, also interested in the concept started a blog, cashtenderoffer.com.  I've resisted the commercial aspects of the concept.  As the paper notes, and as I warned these individuals, there are considerable risks associated with the concepts inherent in arbitraging the position - risks that deserve much more scrutiny and analysis before committing funds.  Still, the concepts are intriguing, particularly when one considers stock exchange offers.  More on that in Part II of this post which will come out sometime in the next few weeks, but the curious may want to take a look at the MergerFund (MERFX) that has been doing this professionally for some time.

All the best,

Ralph