Monday, August 28, 2006

Buyback Binge: Bane or Boon?

News Analysis
August 28, 2006

Business Week Online

Buyback Binge: Bane or Boon?

S&P 500 companies snapped up their own stock at record levels in the second quarter. What does the repurchase rush mean for investors?

Buybacks are back with a bang on Wall Street. According to Standard & Poor's, companies in the S&P 500 index repurchased a record $115 billion of their own shares in the second quarter, up 43% from 2005 and 175% from 2004. The wave of stock buybacks could boost per-share earnings at a time when corporate profits are hard-pressed to keep up their recent double-digit gains.

Oil giant Exxon Mobil (XOM) led the S&P 500 in buyback activity during the second quarter, plowing $6.6 billion into its own shares. Not far behind were Procter & Gamble (PG ) and Time Warner (TWX ). Microsoft (MSFT ) recently made headlines when it bought back $3.8 billion of its shares, and set a $20 billion tender offer to snap up even more (see, 7/21/06, "Microsoft Buyback: Should You Bite?"). On Aug. 25, Home Depot (HD ) tooled up to make an additional $3.5 billion in stock buybacks, raising its total repurchase authorization to $17.5 billion.

For investors, the buyback boom means it's especially important to look beyond per-share earnings when evaluating a company's quarterly performance, analysts say. It might also be a reason to pay more attention to M&A prospects. However, buyback watchers don't expect companies to repeat the mistakes of the late-1990s rash of repurchases, which came back to haunt some stocks after the bull market went bust.

Share repurchases have risen as investors push for companies to put their growing cash hoards to use (see BusinessWeek, 4/17/06, "Blue-Chip Blues"). Buybacks reduce the number of shares outstanding, improving earnings per share. They also absorb excess shares created when employees exercise stock options.

NOTE TO SHAREHOLDERS.  The phenomenon probably isn't going away anytime soon, analysts say. "Buybacks are going to increase as long as the corporate bond market lets them," says Brian Reynolds, chief market strategist at MS Howells. Companies sometimes turn to the bond market to fill the tank with extra cash for repurchases.

Also, a buyback is typically safer for a company than paying a dividend in case earnings should nosedive. "A company can easily raise and lower a share repurchase program," says Jim Clark, an analyst at Sound Shore Management who acts as a sub-advisor for New Covenant Funds. "Doing so with a dividend is much more difficult."

Trouble is, the boost buybacks give to per-share earnings can be misleading. "Investors need to look at the numbers and do a bit more math than sometimes they're given," says Howard Silverblatt, S&P's senior index analyst. For instance, a share might be appropriately valued at 18 times earnings. However, the same share could be overpriced at 18 times an EPS figure inflated by reduced share count.

Lowering the number of outstanding shares through buybacks may also bump the price of stocks higher, if only in the short term, some analysts say. The reason is simple economics: As the supply of shares decreases, the demand should remain steady.

QUESTIONING PRIORITIES.  In fact, buybacks may be helping to hold up the market as consumer spending winds down, according to David Rosenberg, North American economist for Merrill Lynch (MER ). "This is where the 'baton' is being handed off—from the consumer to the shareholder," Rosenberg says in an Aug. 25 report.

Repurchased shares end up back in a company's vault as treasury shares. Many companies will eventually put this wealth to use in M&A activity, says S&P's Silverblatt. So investors should be assessing management's track record at making and executing deals. Silverblatt explains, "It's not how good you are at making widgets, but how good you are at putting companies together."

Meanwhile, the dollar amount of stock buybacks in the second quarter was about equivalent to capital expenditures, according to S&P. This trend raises questions about corporate executives' priorities, some analysts say. "If they can't find anything to do with their money, it makes me wonder what these guys are doing," says Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics. "You would think if you're that flush you would be pouring it into R&D and trying to come up with the next iPod."

Still, companies are snapping up their own stocks for different reasons than in past eras. Buybacks surged in the late 1990s, too, peaking in 2000 at $262.6 billion, according to Merrill Lynch estimates. In those days, many companies repurchased shares primarily to offset the dilution of stock created by stock options, analysts say. Other outfits announced buybacks in hopes of buoying their share prices (see, 9/23/02, "The Buyback Boomerang").

NO LONG-TERM EFFECT.  Most companies today repurchase shares as a way of delivering increased value to shareholders, according to Charles Plohn Jr., managing director and head of Merrill Lynch's special equity transactions group, which specializes in buybacks. "It just seems to be a more rational process at this point," Plohn says. "The fact that we're seeing fewer companies than in the late '90s make the announcements indicates a shakeout from those companies who were implementing them for the wrong reasons."

Further, though buybacks may give shares a quick pick-me-up, they're unlikely to change a stock's direction over the long term. "The price is going to go up or down with or without an open-market buyback program in place," says Plohn, who has followed this area for about three decades.

The repurchase rush may not overturn the entire investing landscape, but it signals that many blue-chips are finding the most appealing place to put their profits is right back into their own shares. Increasingly, investors will want to keep buybacks in mind as they consider which stocks are worth buying—and selling—in the first place.

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