stock options and stock buybacks

I first became aware of the crucial relationship between stock option grants and stock buybacks in the late 1990s.

I was on a research trip to San Francisco, where I had dinner with the new CEO, a turnaround specialist, of a chip design and manufacturing company with a checkered history.

In the course of our conversation, he said that one of his objectives was to ensure he retained top talent.  He went on to mention, as if it were a matter of course, that he would do so by having his firm issue enough stock options to transfer ownership of 6% of the company each year to workers (I’m pretty sure 6% was the number, but it could have been 8%).

I was shocked.

My first thought was that after eight years (six years, if the 8% is correct), there’d potentially be 50% more shares out.  This would massively dilute the ownership interest of any shares I might buy for clients.

My second was that I would have to evaluate the potential for massive positive earnings surprises that would make the stock skyrocket if the turnaround were successful, against the steady erosion of my ownership interest through stock option issuance.  (I decided to bet on skyrocket, which ended up being the right thing to do).

My third was that eventually suppliers of equity capital like me would have to question whether the kind of ownership shift this CEO was presenting as normal tilted rewards too far in the direction of management.

 

After this experience, I began to look much more carefully at the share option schemes of companies that might potentially be in one of my portfolios.  I noticed that in many cases companies had stock buyback programs–pitched as a “return to shareholders” of profits, sort of like dividends–that almost exactly offset the dilution from the issuance of new stock to employees.

This isn’t the case for all companies, but my observation is that it is for many.  I don’t think this is a coincidence.

Part of the rational for buybacks, it seems to me, is simply to prevent dilution of earnings per share, which would arguably help no one.  But at the same time, for the casual observer who looks only at share count and at earnings vs. eps, it obscures how big the corporate stock option issuance plan is.  I don’t think this is an accident, either.  Yes, the information is all in the SEC filings, but the reality is that even many investment professionals don’t read them.

That’s what I find problematic about stock buybacks–that I feel they’re misleadingly described as a shareholder benefit, while their purpose is to play down the level of key employee compensation.

 

 

should corporate stock buybacks be banned?

This is becoming an election issue.

Elizabeth Warren, deeply suspicious of anything to do with finance, regards them as a form of stock manipulation.

Many more mainstream observers note that $7 trillion (according to the New York Times) spent on buybacks by S&P 500 companies has consumed a large chunk of their cash flow at a time when both wage growth and new investment in physical plant and equipment in the US have been paltry.  They argue, without further elaboration that might have the argument make some sense, that the latter are being caused by the former.  Therefore, they think, if only stock buybacks were eliminated, employment and wages would rise and the US would reemerge as a global manufacturing power.  I imagine the same people are saving their old calendars in case 1959 should come back.

There are instances where, in my view, stock buybacks are clearly the right thing to do.  Imagine a publicly traded company that has a profitable business that generates free cash flow, and that has no liabilities plus $1 billion in cash on the balance sheet.  Let’s say the firm’s total market capitalization is $500 million.  In this situation, which actually happened for a lot of companies in 1973, stock buybacks would accommodate shareholders who wanted to liquidate their holdings and create $2+ in value for remaining shareholders for every $1 spent.  I can’t see any reason to outlaw this.

There are also cases—IBM comes to mind–where continual buybacks make investors think that this is all the firm has left in the tank.  So though buybacks keep on generating increases in earnings per share, by shrinking the number of shares outstanding, they no longer support the stock price.  The generate selling pressure instead.  In theory, and provided management understands it can’t play with the big boys any more, the firm should liquidate and return funds to shareholders rather than to continue to destroy value.  Like that’s ever going to happen.  But investors will vote with their feet.  While maybe management conduct should be different, I can’t see how that could be legislated.

My big beef with stock buybacks is that the main purpose they serve is to disguise the gradual transfer in ownership for a company from shareholders to employees that happens in every growth company (more about this tomorrow).  This could be/ should be made clearer.

I also think managements should show more backbone when “forced” into buybacks to satisfy activist investors, in what is the 21st century equivalent of greenmail.

But the idea that barring stock buybacks will cause corporations to make massive capital investments in advanced manufacturing in a country that has a sky-high 35% corporate tax rate, a shortage of skilled labor and rules that bar a firm from bringing in needed technical and management employees from outside is loony.  It isn’t clear to me that removing legislative impediments to investment will be enough to roll back the clock and make the US a manufacturing power.  It isn’t clear, either, that we should want to return to an earlier stage of economic development.  But outlawing buybacks won’t achieve that goal.

stock buybacks: the curious case of IBM

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.

why I don’t like stock buybacks

buyback theory

James Tobin won the Nobel Prize for, among other things, commenting that company managements–who know the true value of their firms better than anyone else–should buy back shares when their stock is trading at less than intrinsic value.  They should also sell new shares when the stock is trading at higher than intrinsic value.  Both actions benefit shareholders and add to the firm’s worth.

True, but not, in my view, a motivator for most actual stock buybacks.

Managements sometimes say, or imply, that share buybacks are a tax-efficient way of “returning” cash to shareholders, since they would have to pay income tax on any dividends received.  I don’t think this has much to do with buybacks, either.  It also doesn’t make a lot of sense, since a majority of shares are held in tax-free or tax-deferred accounts like pension funds and IRAs/401ks.

the real reason

Why buybacks, then?

Years ago I met with the CEO of a small cellphone semiconductor manufacturer.  We had a surprisingly frank discussion of his business plan (the stock went up 20x  before I sold it,  which was an added plus).  He said that his engineers were the heart and soul of his company and that portfolio investors like me were just along for the ride.  He intended to compensate key employees in part by transferring ownership of the company through stock options from outsiders to engineers at the rate of 8% per year!!

Yes, the 8% is pretty extreme. In no time, there would be nothing left for the you and mes.

Still, whether the number is 4% or 1%, the managements of growth companies generally have something like this in mind.  They believe, probably correctly, that they won’t be able to attract/keep the best talent otherwise.

The practical stock option question has two sides:

–how to keep the portfolio investors from becoming outraged at the extent of the ownership transfer and

–how to keep the share count from blowing out as stock options are exercised.  A steadily rising number of shares outstanding will dilute eps growth; more important, it will alert portfolio investors to the fact of their shrinking ownership share.

The solution?   …stock buybacks, in precisely the amount needed to offset stock option exercise.

is there a better way?

What I don’t like is the deception that this involves.

However, would I really prefer to have companies allow share count bloat and have high dividend yields?  What would that do to PE multiples?   …nothing good, and probably something pretty bad.

So, odi et amo, as Ovid said (in a different context).

 

 

stock buybacks: do they make sense?

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.