Share Buybacks and Dividends: The Missing Fine Print

I had an interesting break room conversation about share buybacks. The conversation was in the context of impact of share price and need to provide a down side support. I thought it would be worthwhile to look at it from the dividend investing perspective.

The business media purports a notion that companies engage in share buybacks to support the down side of their share price. This is good because it returns back some of the cash flow and helps the shareholders. So let us look at some hard facts:

As per Standard and Poor’s research published in December 2007, S&P500 index companies spent (three years preceding the published date):

• USD 1.318 trillion on share buybacks;
• USD 1.276 trillion on capital expenditures;
• USD 0.376 trillion on research and development; and
• USD 0.605 trillion on common dividends.

To put these numbers in perspective, the entire market capitalization of the S&P 500 was approximately $14 trillion around that time frame. I was under the impression that corporate America spends more in research and development. However, this observation tells me otherwise. No wonder there is a pattern of lack of innovation. Anyways continuing on our subject…

The share buyback was the highest expenditure while the dividend comes last. Dividends are approximately half the value of share buybacks. But aren’t share buybacks actually returning value to the shareholders? If that’s the case, why are companies not on buying binges in this market environment? The current environment provides the best buying opportunity for their stock. Shareholders need downward support “now”. Instead, companies are saying they are preserving cash. Why didn’t they preserve cash when they had piles of it? The Standard and Poor’s research report made an interesting observation which is as follows:

Traditionally, companies have used buybacks to offset the issuance of employee options, M&A activity, to temporarily support their stock and to reduce their share count. Over the past decade the option portion has accounted for the major use of repurchased shares and actual share reductions the least. Companies usually highlight and lump these expenditures, along with dividends, and present them as a return to investors of shareholder value.

The majority of buybacks are to offset the share count change due to exercise of options by the managements and employees. Typically, the majority of the options are held by management and executive teams, while employees have a minuscule percentage. Buying back stock provides support and helps keep prices at higher levels, so that management gets higher value for their options. This is an indirect way to pay themselves.

In addition, the reduction in share count helps increase the EPS quarter after quarter (assuming controlled buying through out the year). Disciplined Investing posted an article with some good examples for 3M (MMM), BUD, and ADP. Here, let us look at PEP, INTC, and GE.

Pepsi:

From 2003 to 2007, PEP spent USD 10.298 billion in share buybacks and USD 8.099 billion on dividends. During these 4 years, dividends were consistently lower than buybacks. Now the conventional wisdom says the share count should have been reduced by now. The share count reduced from 1.705 billion (2003) to 1.605 billion (2007). This is only 100 million shares. So does USD 10.298 billion buy only 100 millions shares? The math says, USD 10.298 billion/0.1 billion shares, is approximately USD 100 per share. But during this period PEP never went near USD100 per share.

INTC:

From 2003 to 2007, INTC spent USD 22.385 billion in share buybacks and USD 8.422 billion on dividends. During these 4 years dividends were consistently lower than buybacks. The share count declined from 6.487 billion (2003) to 5.818 billion (2007). This is 669 million shares. So does USD 22.385 billion buy 669 million shares? The math says, USD 22.385 billion/0.669billion shares, is approximately USD 33 per share. But during this period INTC was well under 33 (it was at 33 for brief period around Dec. 2004). Same observation is repeated.

GE:

From 2005 to 2007, GE spent USD 25.717 billion in share buybacks and USD 31.264 billion on dividends. Important note is, during these 3 years dividends were consistently higher than buybacks. The share count was reduced from 10.484 billion (2005) to 9.987 billion (2007). This is approximately 496 million shares. So does USD 25.717 billion buy 496 million shares? The math says, USD 25.717 billion/0.496billion shares, is approximately USD 51 per share. But during this period GE was well under 51 (it was never at 51). Same observation is repeated.

I am guessing PEP, INTC, GE just bought back shares to offset the options exercised by management and employees. This is an indirect way to transferring profits back in the pockets for management (and to lesser extent employees).

My take on this issue….

I do not have any particular dislike for share buybacks if they are supported by management’s true intent and honest communication. However, above examples show that there seems to be a “missing fine print” which is not being communicated to the shareholders. It appears that management is more intent towards balancing the options pricing needs (rather than shareholder interests). The misrepresentation and incorrect intent of share buyback is what I do not like.

Disclosure: Long INTC, GE.

Comments

[Patmartin4:]

I agree with the general point of the article, but have two points:
This information is disclosed in the annual reports/10k's, albeit belatedly.
When options are exercised the people exercising them pay the company the exercise/strike price. This $ is probably not included in the figures quoted in the post, and would reduce the net price per share paid for the sock buybacks.

Feb 05 12:40 PM

[john s. gordon:]

buyback occurs when corporation has too much cash on hand & can't find a productive investment for it. apparently in today's business climate research & devel is not considered a productive investment.

i worked for a company doing new product development a while back that was taken over by another company. new owner sid there will be no new products except for acquisitions. pretty soon i was out of a job.
> jack

Feb 05 12:47 PM

[desicon:]

I would rather S & P 500 companies not spend too much on R & D because of their dismal record on developing new products. It is better to distribute the cash in terms of cost cutting measures, share buybacks, dividend distributions and new acquisition.

Feb 05 01:14 PM

[WaveNet Pharma:]

This is a very interesting article providing a fresh insight on a very questionable practice : share buybacks.

The smarter and more responsible companies simply dividend out their excess cash to their shareholders, spend it on R&D and new business development or, if it makes sense, indulge in M&A. Microsoft, Intel and Pfizer are just recent examples of all three, in that order.

Unfortunately too many companies which are run as if they were "hedge funds" ( thanks to our dysfunctional corporate governance system) attempt to manipulate their share price with buybacks. Don't believe for a second that share buybacks improve EPS ; because if you were to look over a longer period ( over 2 years) all companies engaged in buybacks had weaker earnings to show !!! Thinking that "by buying back their shares they will be putting a floor against downward selling pressure", is their untold rationale. The EPS improvement argument is the dumbest thing told to shareholders since buybacks have been legalized.

Any company that does not know anything better to do with its excess cash than buying its own shares is comparable to a person who doesn't know how to save and spends the money on self gratification. Just like the average consumer in America. Sounds familiar ??

Feb 05 01:30 PM

[barry_1942:]

I would think that being a share holder in the three companies you had in your article, we would have better transparency with the corporate managment and Board of Directors. Many investors invest because of dividends and usually these investors are older and tend to hold their investments. The large corporations should take care of these investors as they are part of the life blood of the stock market.

Feb 05 02:03 PM

[Poor Dude:]

The only time a share buyback works to the benefit of existing shareholders is when the shares are bought back at less than book value. Otherwise, the company is just throwing their money away. Far better to just distribute it in the form of dividends.


Also, we need to put the brakes on this issuance of stock as a form of compensation.

Feb 05 02:36 PM

[ilovesum:]

Here I thought they were doing it to benifit the shareholder , ha ha ha !!!
Now I understand why companies will buy their stocks at very high historical prices . It also makes sense that these buybacks occur in bunches not over an even period so that the buyback won't create a false high stock price.
Hmmm , the shareholder and the public get screwed again , what a shock.

Once again the arguement for holding periods of 5 years for stock options would work to decrease short term greed and ensure the management protects the long term viability of the company. The management should also only be allowed to dispose of a certain amount per year , lets say equal to one years options they were paid.

Angelo Mozilla from Countrywide dumped hundreds of millions of dollars of Countrywide in 2006. If he was still holding those shares I think his incentive to do the right thing would have changed the way he ran the company. He had no incentive to think 2 seconds past the high point when he dumped his stock.

These guys make millions in guaranteed paychecks plus options so don't worry about them starving while they wait for their options to become liquid. I think they can live on 5 or 10 million a year .
no incentive to think long term , only short term and fill his pockets like a bandit.

Feb 05 10:48 PM

[Poor Dude:]

And slowly, but surely, the average American is catching on. All it took was a 40 percent annual drop in everyone's wealth and retirement portfolio, to make them start paying attention.


I wouldn't want to be anyone on the board of directors or in a senior management position of a publicly-traded company these days. If the situation doesn't reverse very dramatically here ... and very soon ... then those people might legitimately be concerned for their lives. While the average American will just be upset and hem and haw and bitch about it, there are maybe one in a thousand or so who will actually be ticked off enough to go out and do something about it. To seek vengeance. Or justice, I guess --- depending upon how you look at it.


Do the math. If your actions caused terrible hardship to a thousand people, then one of them might be gunning for you. If your actions caused hardship for 10,000, then 10 might be gunning for you. And if your actions harmed millions (or tens of millions, or hundreds of millions), then ...


:(


It's past time to right our ship. Let's get started!

Feb 05 11:12 PM

[ChipSeal:]

Return the profits to the owners to do as they like with it. Many will buy more shares with it- a true share buyback!

Feb 06 09:35 AM

[notsosmart:]

nobody cares about stockholders.get used to it.if you cant you have to quit the market cause its not changing.

Feb 06 02:22 PM

[brasscop:]

Let's extrapolate. If your company bought back all shares but yours, you'd be CEO! When buying a stock you implicitly trust management. So, if that's where your board invests, rejoice in their insight.

Feb 06 02:40 PM