Earlier this month Rick Santelli of CNBC went on another one of his epic rants. This time the rant was over Fed Chairmen Ben Bernanke and Janet Yellen treating the U.S. economy like it was in crisis. He and CNBC's Steve Liesman got into a heated debate about whether easy money had created a stock market bubble. At the 2:50 mark of the video, Santelli and Liesman got to the crux of the issue:
Steve Liesman: Rick I think there are many ways that the market can express its concern over inflation. You can sell equities.
Santelli: Why would anyone sell equities ... when we're giving companies super low rates to buy back their shares to artificially make P/E ratios look handsome when they are still a pig?
I personally do not agree with everything Rick Santelli has said in the past, but I am riding with him on this one. Several companies are engaging in share buybacks - or attempting share buybacks - to mask a slow growth or no growth in earnings. By reducing the shares outstanding, companies can growth earnings per share or enhance their price-to-earnings ratios. The following chart shows share buybacks from 1998 to 2014:
According to MarketWatch, companies in the S&P 500 bought back $159.3 billion of their own shares in Q1 2014. That is second all time behind a peak of $157.7 billion in Q2 2007. Three such companies attempting to obfuscate a slow growth in earnings through share buybacks are Bed Bath & Beyond, Inc. (NASDAQ:BBBY), Sirius XM Holdings, Inc. (NASDAQ:SIRI) and Lululemon Athletica, Inc. (NASDAQ:LULU).
Bed Bath & Beyond
From fiscal year 2012 to fiscal year 2014 Bed Bath & Beyond's revenue grew from $9.5 billion to $11.5 billion. Its operating income margin declined from 17% to 14% during that period. Net income grew 5% and declined 1% in fiscal year 2013 and fiscal year 2014, respectively. However, earnings per share grew in both fiscal years as the weighted average shares outstanding declined.
Revenue was flat and operating income margin declined from 12% to 11% from quarter end June 1, 2013 to quarter end May 31, 2014. Net income declined 8% during that time frame, yet earnings per share was $0.93 in each quarter as weighted average shares outstanding declined from 218 million to 202 million. From fiscal year end February 25, 2012 to quarter end May 31, 2014, Bed Bath & Beyond spent a cumulative $3.8 billion on share buybacks.
Three Year Stock Chart
The following chart illustrates Bed Bath & Beyond's three year stock performance. The stock peaked around $80 per share in January 2014. It reached a year-to-date low in June 2014 after announcing earnings per share of $0.93 in the quarter end May 31, 2014, which disappointed the market. Though its earnings per share was flat versus the prior year period, Bed Bath & Beyond's actual net income declined 8% and the market was not fooled by it. At a $12.4 billion market capitalization, Bed Bath & Beyond trades at 13.1x earnings.
Revenue increased from $3.0 billion to $3.8 billion from 2011 to 2013, while Sirius' operating income margin expanded from 22% to 27%. Net income declined from $433 million in 2011 to $377 million in 2013 - a decline of about 13%. However, earnings per share only declined from $0.07 to $0.06 during that period as [i] the company spent $1.8 billion on share repurchases in 2013, which [ii] reduced weighted average shares outstanding from 6.5 billion to 6.4 billion.
Sirius' Q1 2014 revenue of $1 billion was 11% above Q1 2013 revenue of approximately $900 million. Its operating income was flat over that period as its operating income margin declined from 28% to 25%. In my previous article I highlighted that part of the operating income margin decline was due to an increase in royalties Sirius pays for music:
Revenue share and royalty fees was 20% of revenue for Q1 2014, versus 17% for Q1 2013, causing gross margin to decline to 61% from 63%. Increase in such fees was primarily attributable to greater revenue subject to royalty and/or revenue share arrangements, and an increase in the statutory royalty rate for the performance of sound recordings.
Sirius' net income declined 24% in Q1 2014, yet its earnings per share was flat at $0.02 vs. $0.02 for Q1 2013; weighted average shares outstanding declined from 6.3 billion to 6.1 billion after the company spent an additional $1.4 billion in share repurchases. The calculation is as follows: [i] $1.8 billion cumulative repurchases from full year 2013 to Q1 2014, minus [ii] $465 million in share repurchases through Q1 2013. On the article, Sirius XM Is No Longer A Growth Stock, I argued that the company's earnings growth did not justify its 54x price-to-earnings ratio, but longs were having none of it:
Commenter 1: Let us look at one more extremely important number that you are so diligently overlooking. This number describes Free Cash Flow or "FCF." 2013 Q1 FCF was $142 million ... FCF for Q1 2014 is $223 million - that is a 56% growth ... The author is not just cherry picking his data to justify his agenda of bashing the company ... but is flat wrong using incorrect data or blatantly overlooking most important information that defines [the] company's growth.
Commenter 2: In December, 2012, Sirius announced a two billion dollar share buyback and a special one time $.05 dividend. If most of the FCF is going to the share buyback, does that not satisfy you that Sirius is increasing share value for shareholders? It seems like you haven't done much research into all the cash being generated and what the company plans on doing with it. I don't think that you can make a buy/sell decision without considering that.
Three Year Stock Chart
The following chart illustrates Sirius' three year stock chart. Just like Bed Bath & Beyond, the stock hit a year-to-date low of $3.07 after earnings were released in April, but have since bounced back.
Lululemon is a company that had plans to engage in stock buybacks. I think its historical financial results will illustrate why it wanted to follow the example of Bed Bath & Beyond and Sirius.
Lululemon's revenue increased over 50% from fiscal year end January 29, 2012 to fiscal year end February 2, 2014. Its operating income margin declined from 29% to 25% during that period. Also notice how its earnings per share growth closely tracked its actual earnings growth. The company did not engage in stock buybacks so it did not get a pick up in earnings per share growth like Bed Bath & Beyond and Sirius.
The fact that earnings per share growth closely tracked net income growth really did not matter to the market as long as Lululemon's earnings growth was robust. However, the company hit a wall for the 13 weeks ended May 4, 2014. Revenue grew 11% over the prior year period. Operating income margin ticked down to 18% from 19%, and operating income grew about 5% versus the prior year period. However, net income declined 60% to $19 million, versus $47 million in the prior year period; earnings per share also declined 59%.
The sharp decline occurred when Lululemon's provision for income taxes increased $32 million or 16% to $52 million, versus the $20 million recorded in the 13 weeks ended May 5, 2013. The tax issue stemmed from the company's plan to buy back up to $450 million shares. The market saw the buyback plan as [i] Lululemon's attempt to increase earnings per share through financial engineering and [ii] a signal the company was no longer a growth stock:
The company said it would repurchase up to $450 million of its stock. Such buybacks are supposed to instill confidence among investors, on the theory that a company is generating lots of cash and thinks its stock is too cheap ... investors' takeaway may well be that the company doesn't expect its growth trajectory to turn back up and is indulging in a little financial engineering to boost earnings per share.
Three Year Stock Chart
After Lululemon's Q1 earnings report disappointed the market, the stock plunged 16% from $44 to $37 per share on June 12th. Unlike the shares of Bed Bath & Beyond and Sirius, Lululemon's stock has never recovered from the share decline in mid-June. The CEO hired Goldman Sachs to seek other alternatives to help improve the stock price - even a potential leveraged buyout - but nothing much has come of it. The stock currently trades at 20x earnings.
The earnings of Bed Bath & Beyond, Sirius and Lulelemon are all in decline. However, the stock prices of Bed Bath & Beyond and Sirius have not fallen has sharply as Lulelemon's due to stock buybacks that make earnings per share look more attractive than they otherwise would have been. CNBC's Rick Santelli is correct in that stock buybacks can sometimes obfuscate a company's true earnings growth.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.