Category Archives: Stock options

Warren Buffett and Dow Chemical (DOW)

August 25, 2016 By in Convertibles, Preferred Stock, Stock ideas, stock market, Stock options, Uncategorized Tags: , , , , , 1 Comment

Today’s Wall Street Journal contains a front page article that will be widely viewed on Wall Street, I think, as a bit of comic relief.

In times of financial stress, cash-short companies have tended to go to Berkshire Hathaway for financial assistance.  If successful, they receive both money and the implicit endorsement of Warren Buffet.

In 2009, it was DOW’s turn.  It wanted to acquire Rohm and Haas, another chemical company.   The best deal it could find for a needed $3 billion was in Omaha, where Berkshire took a private placement of $3 billion in DOW preferred stock, with an annual dividend yield of 8.5%.  The preferred has been convertible for some time now into DOW common (yielding 3.4%), at DOW’s option, provided DOW has traded above $53.72 for a period of at least 20 trading days out of 30.

DOW shares were trading below $20 each when the deal was struck seven years ago.

On July 26th, the shares breached the $53.72 barrier and traded above it for five consecutive days–the final two on extremely heavy volume–before falling back.  At the same time, according to the WSJ, short interest in the stock has risen sharply.  In other words, someone has been a heavy seller, using stock borrowed from others.

Who could that be?

Although nothing is stated outright, the strong implication of the article is that the shortseller is Berkshire, which stands to lose $150 million+ a year in dividend income on conversion.

Part of the Wall Street humor in the situation is that the playing field isn’t level.  It’s perfectly legal for Berkshire to sell DOW short, although it does seem to cut against the homespun image Mr. Buffett has been at pains to cultivate for years.  On the other hand, however, DOW would run the risk of being accused of trying to pump up its stock price (and the value of management stock options) if it went out of its way to absorb any unusual selling.

 

stock buybacks: the curious case of IBM

February 20, 2015 By in activist investing, Industry Analysis, stock market, Stock options, Technology Tags: , , , , , Leave a comment

Regular readers will know that I’m not a fan of stock buybacks by companies.  I believe that even though buybacks are advertised as returning cash to shareholders in a tax-efficient way, their main effect–even if not their purpose–is to keep the dilutive effects of management stock options away from the attention of ordinary shareholders.  Admittedly, I haven’t done a study of all firms that buy back stock, but in the cases I have looked at the shares retired this way somehow end up offsetting new shares issued to management.  As a result, you and I never see the slow but steady shift in ownership away from us and toward employees.

In recent years, activist investors have made increasing stock buybacks a staple of their toolkit for “helping” stick-in-the-mud companies improve their returns.  Certainly, accelerating buybacks can give a stock an immediate price boost.  But since I don’t believe that the usual activist suspects have your or my long-term welfare as shareholders at heart, I’ve had an eye out for cases where extensive buybacks have ceased to work their magic.

I found IBM.

Actually I should put the same ” ” around found that I put around helping two paragraphs above.  I stumbled across an article late last year in, I think, the Financial Times that asserted all IBM’s earnings per share growth over the past five years came–not from operations–but from share buybacks.  A case of what Japan in the roaring 1980s called zaitech.  Hard to believe.

I’ve finally gotten around to looking.  I searched in vain for the article.  I found a relatively weak offering from the New York Times Dealbook, whose main source appears, somewhat embarrassingly for the authors, to have been IBM market-speak in its annual report.  I did find an excellent two-part series in the FT that I’d somehow missed but which appeared earlier this month.  It’s useful not only conceptually but also for IBM history.

IBM

The FT outlines the essence of the IBM plan to grow eps from $11.52  in 2010 to $20 by this year–a target abandoned last October by the new CEO..  Of the $8.50 per share advance, $3.50 was to come from revenue growth, both organic and from acquisitions; $2.50 each were to come from operating leverage–which I take to be the effect of keeping SG&A flat while revenues expanded–and share buybacks.

What actually happened from 2010 through 2014 is far different:

–IBM’s revenues, even factoring in acquisitions, fell by 7% over the five years

–2014’s operating profit was 5% higher than 2010’s

–net profit grew by 7.0%, aided by a lower tax rate,

–nevertheless, earnings per share grew by 35%!

How did this happen?

Over the five years, until share buybacks came to a screeching halt in 4Q14, IBM spent just about $70 billion on the open market on its own stock.  That’s over 3x the company’s capital expenditures over the same period.  It’s also about 3x R&D expenditure, which is probably a better indicator for a software firm.  And it’s over 3x dividend payments.

The buying reduced the share count by 315 million to 995 million shares.  The actual number of shares bought, figuring a $175 average price, would have been about 400 million.  I presume the remainder are to offset shares issued to employees exercising stock options (although there may be some acquisition stock in there–no easy way to find that out).

results?

What I find most interesting is that, other than a flurry in the first half of 2011, the huge expenditure did no good.  IBM shares have underperformed pretty consistently, despite the massive support given by the company.  And IBM has $13 billion more in debt that it had before the heavy buybacks began.

Where is the company now?

I don’t know it well enough to say for sure, but it appears to me that it has taken recent earnings disappointments to jolt IBM into the realization that the 2010 master plan hasn’t worked.  A half-decade of the corporate equivalent of liposuction and heavy makeup has not returned the firm to health.  Instead, IBM has burned up a lot of time   …and a mountain of cash.

I think it’s also reasonable to ask how ordinary IBM shareholders have benefitted from the $60+ per share “returned” to them through buybacks.  I don’t see many plusses.  The stock dropped by about $20 last October, when IBM officially gave up the 2010 plan, so some investors were fooled by the company’s zaitech.  But spending $60+ to postpone a $20 loss that happened anyway doesn’t seem like much of a deal.

Only the board of directors knows why almost five years elapsed before anyone noticed the plan had long since gone off the rails.

Google’s proposed new class of common stock

April 13, 2012 By in Current Market Thoughts, Industry Analysis, internet, Japanese development, Stock ideas, Stock options, Stock Splits Tags: , , , , , , , , , Leave a comment

the C class announcement

Yesterday, in conjunction with its release of 1Q12 earnings, GOOG published a letter to shareholders on its website.  In it, Larry Page and Sergei Brin outline their plans to create a new class of stock–C shares.

On shareholders’ approval, the new C shares will be distributed as a stock dividend, on a one-for-one basis, to all holders of A and B shares.  C shares will be publicly traded on NASDAQ, using a different ticker symbol from the “GOOG” the A shares use.  As will continue to trade, though.

no voting power

The sole difference among the share classes will be in voting power.  Each A share has one vote; each B share, held by corporate insiders, has 10.   C shares will have no votes.

Since holders of B shares–principally Mssrs. Page, Brin and Eric Schmidt–wield over 70% of Google’s voting power, shareholder approval is a mere formality.

Google intends to file full details of the issue with the SEC next week.

why do this?

…to keep voting control of Google in the hands of the current B shareholders.

How could control be lost?

…through a combination of sales by B holders, issuance of new A shares through stock options or acquisitions for stock.

current shares outstanding

According to the company’s 2011 10-K filing, 67.2 million class B shares, representing 672 million votes, were outstanding on December 31st.  258 million As, representing another 258 million votes, were also out.  Employee stock options on just under 10 million new A shares had been granted and remained to be exercised.  (Notably, I think, the stock option count is growing very slowly.  Google only granted options on 718,000 new shares last year.)

Therefore, assuming all stock options grants are exercised, A shares represent 28.5% of the total vote.  Bs represent 71.5%.

implications of the Cs

control structure frozen

The most obvious is that the new class will provide a way for the company to issue potentially large amounts of new shares without altering the current control structure of the company.  Google has already said future employee stock option grants will be for Cs.  Bs continue to rule.

price of the Cs vs. Bs

It’s not clear that the Cs will trade at the same price as the Bs.  Arguably, voting power should be worth something.  But in this case, as the company is currently constituted, the Bs’ votes basically have no value.  So you’d think the two prices should at least be pretty close.

stock options

Stock options don’t seem to me to be a big deal–or any deal at all.  Here’s what I mean:

If we assume all outstanding stock options are exercised, the company currently has a total of 940 million votes.  Bs have 672 million, with 268 million more for the As.

For the moment, let’s ignore the possibility that insiders sell a significant number of Bs to get walking-around money.  Yes, company rules require that Bs be converted into As before being sold, so no outsiders can end up with the super-vote shares.  Bs, therefore, can–and in the past have–disappeared.  And, yes, Mssrs. Page and Brin are halfway through a modest (for them) sell program that goes into 2015.  But put these thoughts to the side.

As things stand now, A shares can only achieve a voting majority if over 672 million are outstanding.  That’s an extra 404 million shares.  At the 2011 stock option issuance rate, the As take over in the year 2575, or 563 years from now.  At the 2010 issuance rate of 1.7 million, the As grab the reins in a mere 238 years, in 2250.

Suppose B holders sell 10% of their stock–because they need a loose $4.4 billion.  That would imply that the Bs outstanding shrink to roughly 6 million and As expand to 275 million.  In this case, the As still need 325 million more shares to take over.  That would happen, at the earliest, toward the end of the next century.

Even for long-term thinkers like Google, dealing with stock options worries can’t be a pressing issue.

stock-based acquisitions

This is the only reason I can see for the C share move.

True, Google has $44 billion+ in cash; operations generated $14 billion+ last year.  But a seller may well prefer stock to cash.  And, of course, a potential acquisition could be very large.  It could also be very large and very sick, needing a big infusion of cash after the purchase.

Yes, the founders’ letter says  “we don’t have an unusually big acquisition planned, in case you were wondering.”  I’m sure that’s true.  But I’d emphasize the word “planned.”  It seems to me that Google may well have decided it needs to make an acquisition of a certain type over the next couple of years and have developed a list of possible candidates. The next step is figuring out how to pay for it–which is what I think Google is doing now.

Who know what such an acquisition might be?  I wouldn’t care to bet on anything.  But I do have a guess, however   …somebody like Sony.  But that company has been such a train wreck for such a long time that I don’t see any percentage in speculating that Google would rescue them.  There are also severe legal obstacles that Tokyo has erected to deter foreign takeovers of its domestic firms.  On the other hand, Sony is a post-WWII upstart, not part of the establishment.  And the company does have TV technology, cellphones, tablets/PCs and the Playstation in tens of millions of homes around the world.

 

 

 

 

stock buybacks: do they make sense?

June 13, 2011 By in Stock options Tags: , , , , , , , Leave a comment

In this morning’s Financial Times, columnist Tony Jackson, an interesting and insightful reporter, writes about corporate stock buybacks.  He observes that in today’s world company buybacks tend to “not only respond to the ebb and flow of the markets, but also amplify them.”  Firms tend to buy a lot of stock when the price is high and only a little when the price is low.  In contrast, the “rational approach” would be to buy low and sell high.

Tobin’s Q ratio

Although Mr. Jackson doesn’t mention the Yale economist James Tobin, his “rational approach” is a restatement of Prof. Tobin’s Nobel Prize-winning work, best known by the term “Q-ratio.”   According to Tobin, corporate managements know better than anyone else the intrinsic value of their companies.  Savvy CEOs issue stock when the quotient (the “Q”) of   market value of the firm/intrinsic value of the firm   is greater than 1.  They buy stock back when the ratio is below 1.

Based on this criterion, the tendency of companies to “buy high” and the practice of making acquisitions for stock and then buying back in the open market the same number of shares just issued (one of these actions must be wrong) make no sense.  I think there’s a method to the madness, however, even though it may make no Q-ratio sense:

my observations

taxes

1.  In the US at least, if you sell your company to an acquirer, it can make a big difference whether you take stock in the acquirer or cash for your shares.  If you sell for cash, you owe capital gains tax on the transaction in the year the deal occurs.  If, on the other hand, you trade your shares for equity in the acquirer, the IRS considers that you are maintaining your equity holding.  True, tax will eventually be due when you sell the new shares for cash, but an equity swap allows you to postpone the taxable event, or even spread it out over a number of years.

In cases where this is an important consideration for the seller–that is, any time the capital gains tax for controlling shareholders (or management) would be large–a share swap will cost the acquirer 10% or so less than an all cash deal.  Buying back on the open market the same number of shares issued in an acquisition may not be the most brilliant use of corporate cash, but it’s not clearly irrational, either.  It makes the transaction a synthetic all cash deal.

stock options

2.  Some companies may repurchase stock because they see it as the best use of their funds.  For most, however–be warned that this is a pet peeve of mine–I think the real relationship is between stock buybacks and the exercise of stock options held by company employees.

Stock buybacks offset the dilution from stock option exercise.  The effect of this activity, if not the intention, is to conceal the (potentially large) portion of management compensation that comes from awards of company stock.

In my experience, smaller entrepreneurial companies talk the most openly about the key role that transfer of a certain percentage annually of the company’s equity away from existing shareholders and into the hands of management plays in keeping highly-talented people as employees.  The target may be 2% of the firm’s equity.  During the internet bubble I heard numbers as high as 8% bandied about.

No matter what the target, issuing large chunks of equity to management may not go down well with the current owners, whose percentage ownership is being diluted.  By buying back enough stock in the open market, and thereby keeping the annual share count stable, the extent of the ownership transfer becomes less noticeable.

3.  By the way, going back to Tobin’s Q, it’s always amazed me how many Nobel Prizes have been awarded to financial economists for academic formulation of the common sense nostrums of pre-World War II professional investors.