Activist investor Carl Icahn recently announced his third round of $500 million investment in Apple stock. His stated goal was to push for a larger share buyback program. Nine days later Tim Cook announced that Apple had purchased $14 billion in shares in the two weeks since its price dropped 8% after the most recent earnings disappointed Wall Street expectations. Mr. Cook boasted that Apple (AAPL) has thus far bought back $40 billion in the last year, the largest and fastest buyback in corporate history. Mr. Icahn later tweeted his kudos to Apple's aggressive share repurchases and many investors and analysts alike seem to be over the moon with the buyback program. Despite all the celebration over "returning cash to shareholders," I was curious as to how buybacks compare to dividends in terms of maximizing shareholder value. The more I researched, the more shocked and dismayed I became at what appears to be a strong trend by US companies of buybacks that appear to be little more than a squandering of shareholder wealth.
A quick summary of how buybacks are supposed to work. Companies with extra cash and strong cash flows, whose shares are undervalued, repurchase shares and then retire them. This decreases the overall share count resulting in each remaining share automatically commanding a larger piece of the company's profits.
Additional benefits include:
-Valuation metrics improves, such as the PE ratio drops.
-Stock price rises.
-Tax benefit compared to dividends.
-Sends message that management is confident in the company's future and shares are undervalued.
-Buybacks are temporary unlike dividends, which gives management greater flexibility in terms of capital allocation going forward.
At least this is supposed to be how buybacks work. However here is what usually happens.
1. Buybacks are mostly bungled and destroy shareholder wealth: 2/3 of the time companies initiate buybacks after their stocks have risen and become overvalued. When prices drop, such as during market meltdowns and great companies become massively undervalued, (the best time for buybacks) companies typically stop share repurchases. By buying when shares are high, and overvalued, companies are essentially buying $1 for $1.25, destroying shareholder value in the process.
Several academic studies have shown that most share buyback programs don't improve investor returns. As Gregory Milano, of Fortuna Advisors puts it, "companies executing heavy buybacks tend to underperform over the long run."
In fact, as Jim Morrow, Fidelity Research Equity Income Fund Portfolio Manager points out, "Buybacks are probably the least analyzed tangible event that companies spend so much money on."
He argues that Returns On Investment (ROI), the basic metric companies make to determine what actions to take and which most companies set at 10% before taking action, are ignored when it comes to buybacks. In fact, when he studied 258 companies and the history of their buybacks, he found that not only did most fail to return 10%, but a majority, 138, achieved a negative ROI.
2. Buybacks offer management maximum flexibility while hamstringing the actual owners of the company, the shareholders. Had those funds been returned to investors as dividends then shareholders would have been given flexibility. Believe the company is undervalued? Reinvest the dividend. Believe it's overvalued? Invest it elsewhere. Need funds, either for retirement, children's college or an emergency? No need to sell your shares, (and incur capital gains), just use the dividend income. Dividends offer shareholders, (the true owners of the company) maximum flexibility. In contrast buybacks favor management with flexibility at the expense of owners because shareholders' cash is at the mercy of management in terms of when and how much to buy.
They place all the benefits of saving, investing and patiently letting a company grow one's wealth into something completely hypothetical, capital gains. Let's say a company had an aggressive share buyback program and 10 years on, the share count is half what it started as, and the share price is doubled. Sounds great, right? However imagine that you're a retiree or someone who was counting on that money to pay for your kid's college education and 6 months before you needed it the market experiences a panic and the stock drops by 50%. 10 years of share buybacks, all that patience, all that savings, all the opportunity cost, gone, you have nothing to show for your 10 year investment. Because of bad timing, Mr. Market has stolen your gains. However, with dividends, you would have received your reward up front, able to reinvest it as you saw fit and no matter how bad the market melted down, you still would have 10 years of dividends to show for your patience and thrift.
3. Buybacks are a form of accounting shenanigans:
Most managers receive bonuses for certain metrics, most commonly EPS growth. So buybacks are one of the easiest ways of increasing EPS through artificial means, as opposed to organically growing the company. Thus, one of the easiest ways for management to give themselves a bonus, is to use shareholder, (owner) cash to boost EPS and alongside it the share price. After all earnings up, share price up, what's not to like? Everyone wins, right?
Well except for the owners of the company, the shareholders, whose cash is being used to by management to justify increased bonuses.
4. Buybacks are a means of covering up shareholder dilution and exorbitant compensation.
In 2012 Johnson & Johnson (JNJ) purchased Synthes for $19.7 billion in cash and stock. Over the next year, JNJ bought back nearly $13 billion in stock. The total share count went up by 2%. This was because just over $13 billion of JNJ stock was issued to help pay for the acquisition. Now this by itself was not necessarily a bad thing. If JNJ stock were trading high and overvalued, then issuing shares would have been a cheap way of raising capital to buy a potentially undervalued and worthwhile asset. Such a company could lead to strong future growth and increased shareholder value. This would be a smart decision. However, management heralded the buyback as a means of returning cash to shareholders, when it was merely offsetting dilution used to fund the acquisition, one whose value to the company might prove largely worthless.
Companies often use buybacks to cover up for such dilutional actions, including issuing shares for acquisitions, and as I said above, sometimes this is a good idea. However given that 60-80% of mergers and acquisitions fail, should management be printing shares to make them, then buying back those same shares at overvalued levels? Ask long suffering shareholders of Cisco Systems, (CSCO) or Microsoft, (MSFT) about how they feel about these companies' long histories of disastrously expensive and failed M&A activity. Now ask them how they feel to find out that those acquisitions were largely funded by printing shares, diluting their investments, setting their cash on fire, (with the cash portion of the acquisition) and then announcing a buyback that only undid the dilution. Rather than being honest about the nature of the buybacks, they were presented as a sign of shareholder friendly management.
That is not to say that all buybacks are bad. The average buyback cost $1.18 billion and achieved an ROI of 7.7%. This varies by sector with technology being by far the worst perpetrators of mismanaged buybacks that are little more than thinly disguised attempts at offsetting massive shareholder dilution, with an average ROI of -12.2%. Allow me to explain using Intel (INTC) and Microsoft as two of the worst perpetrators of mismanaged buyback programs.
First, it's important to understand that most companies have some form of share dilution, because of stock option based compensation programs. This is most prominent in tech companies and most analysts agree that they are necessary to attract and retain top talent. I have no quibble with this argument; my outrage is over how buybacks are presented as a benefit to shareholders when they are mostly used to transfer shareholder cash to the management that is already well paid. If stock options are necessary then better to allow the share count to increase and explain to shareholders that this dilution is a necessary evil, the cost of doing business in the tech sector.
Between 1990 and 2013, Intel bought back 6 billion 56 million shares worth $91.1 billion. The share count went from 6 billion to 5 billion.
According to Intel's own investor relation website, they should have bought back every single share over the last 23 years, yet only decreased the share count by 1 billion. This means that the true cost of each retired share was about $91. Given that Intel has never traded over $80, this seems to argue that management over paid immensely for each share retired. Over the last 23 years, Intel management has granted themselves 5 shares in stock options for every 1 share retired. That means that 83% of the $91 billion spent on buybacks, or $75.5 billion, went not to retiring shares and returning cash to shareholders (as it was presented at the time of the announcement), but was transferred from the owners of the company to the employees.
Now am I saying management and employees don't deserve fair compensation? Of course not. If it takes a lot of money to attract the best talent in tech then pay whatever it takes. However be honest about it and don't hide your pay in the form of dilutional stock options. Don't lie to shareholders and tell them you're decreasing share counts and doing buybacks for their best interest when 83% of the money is going into your pockets. If management thinks that they are worth that much more money, then vote to pay yourself what you think is fair and let shareholders put it to a vote as well. After all, shouldn't the owners of the company have a say in how much employees get paid? How many Intel shareholders know this information about their fabled buyback program? How many would still support it if they knew the truth? And how many would advocate instead that money go towards higher dividends, so that $75.5 billion in owner cash had actually been returned to shareholders as management claimed it had been. Between 1990 and 2013 Intel paid $34.415 Billion in dividends. That's $2.67 in buyback per $1 in dividends, money that the owners of the company actually received. What if that cash had been used instead to pay increased dividends? In that case Intel would today have an annual dividend of $2.4/share, a yield of 13.13%. Of course in reality if Intel paid out that high of a dividend the share price would likely be much higher, the yield closer to 4-5% and the share price trading between $48-$60.
However, perhaps you think that Intel management has been stupendous and deserves every penny, even if it was hidden from average shareholders in the form of stock option dilution and missed opportunity cost of much higher dividends. Let's look at an example of a company that has bought back more stock than any other in history and see if their management has been worth the extra tens of billions of dollars they have been secretly paying themselves.
Between 2004 and 2013 Microsoft spent $109.7 billion buying back 4 billion 15 million shares. In the process its share count declined from 10.9 billion to 8.3 billion, a net decrease of 1.6 billion shares.
2.4 billion of the shares that were repurchased, 60% of the total shares representing $66 billion of shareholder cash, was used to offset the dilution of stock options management awarded themselves. This is the same management led by Steve Ballmer, whose greatest contribution to Microsoft was 14 years of uncharismatic leadership, lack of innovation in products and massively overpaying for 16 mediocre to disastrous acquisitions costing $14.892 billion.
Not only did Microsoft management pay themselves nearly $6.6 billion/year in stock options, but they also used share printing and shareholder dilution to pay for such acquisitions as online marketing firm aQuantive, which they later wrote off as a $6.2 billion failure. Then to add insult to injury, they used additional shareholder cash to purchase back the shares they used to pay for their mistakes.
In fact, Microsoft's management spent $110 billion buying back just 1.6 billion net shares, which is an average price of $68.75 per retired share. Hardly what I'd call shareholder friendly given Microsoft has never traded that high, once more proving that management massively overpaid per retired share and thus squandered shareholder cash.
Now in fairness to Microsoft they did return $85.9 billion in dividends to shareholders between 2004 and 2013, (though 35% of that was in the form of a single special dividend in 2004). Had Microsoft instead spent all the money on dividends, then the annual dividend/share today would be $2.55 and the yield would be 7.07%. In actuality the higher dividends would have caused the share price to increase bringing the yield down to 4-5%, meaning a share price of $51-$63.75.
If you are a shareholder of Intel or Microsoft, what would you prefer? The buybacks and acquisitions you got? Or a dividend yield of 4-5% and Intel trading around $54/share and Microsoft at $57? Which do you feel would have maximized your shareholder value?
Returning to our original story about Mr. Icahn and his obsession with ever larger share buybacks, I think that it's important for long term investors in Apple to keep something in mind.
First, Mr. Icahn is a short term investor. His history is of buying a stake in a company, lobbying for buybacks and dividends and then selling out after a relatively quick increase in price. Studies show that soon after a buyback is announced share prices typically do increase, for a brief while. So long term investors in Apple may call Mr. Icahn an ally, but never think that he won't argue for the largest possible buyback, as quick as possible, even if it's at the expense of increased dividends. His goals are not the same as long term Apple investors who view the company as a dividend growth company.
The case against buybacks that I have presented in this article may seem harsh, even extreme. Some might say it's unfair to Apple. Maybe Apple isn't like Microsoft or Intel. Maybe they don't issue as many stock options.
Actually they do. However perhaps they have slowed down recently and won't abuse the largest buyback program ever announced. After all, the initial $10 billion over 3 year buyback was stated by Tim Cook to be designed to only offset dilution. However, I would advise Apple shareholders to keep a close eye on the amount of stock options being issued and how fast the share count declines. It's possible that this time will be different, but the tech sector's history of share buybacks is littered with destroyed shareholder wealth. For this very reason I support increased dividends over buybacks, especially when it comes to technology companies. Dividends are a lot harder to manipulate and in the end I believe that the shareholders, the true owners of companies, should be given the choice of what to do with cash that is rightfully theirs.