Do Buybacks Destroy Shareholder Value?

Includes: AAPL, JNJ
by: Alan Brochstein, CFA

"Capital allocation" is one of the biggest buzzwords on Wall Street these days, with investors and analysts focused more than ever after 2008-09 on how exactly companies spend their "earnings". The choices are rather limited: Reinvest in the business (capital spending), pursue M&A, hang onto it for a rainy day (like AAPL) or return it to shareholders through either dividends or share repurchases. With respect to that last choice, which is an increasingly popular option due to generally very strong balance sheets that have resulted in excess capital, there is a long-standing debate on the "best" way to do so.

Each method, neither of which precludes the use of the other, has its advantages and disadvantages. Historically, dividends were taxed as ordinary income, which created an even larger issue for tax-paying investors than exists today at more favorable rates for "qualifying" dividends. Share repurchases, on the other hand, impact only those shareholders who choose to sell.

To answer the question raised in the title, judging how well a company allocates capital depends on a lot of factors. Quite simply, sometimes a share repurchase is smart, while sometimes it is quite stupid.

After a lost decade, which has stretched now beyond a decade to almost 13 years since the S&P 500 first traded at the current 1264 level, it's not surprising to see the pendulum swinging towards dividends and away from share repurchases. After all, it's very easy to find "failed" share repurchases. One has to look back only a few years to find examples of companies that bought stock in 2007 before their shares plunged in 2008 and have yet to recover.

Often a company is judged to be irresponsible with shareholder capital after the fact. While it's not as common for a company to be raked over the coals for an aggressive dividend strategy, often a company ends up paying unsustainably high dividends.

While I have already suggested that buybacks can be a terrible waste of shareholder money, I want to share my thinking on why they can make a lot of sense too. There are two big-picture scenarios I will address: Using excess cash on the balance sheet and reinvesting normal cashflow.

Sitting on a Wad of Cash - Apple

One of the big debates right now for AAPL is what to do with its massive accumulation of cash (not all of which can be used because doing so would entail tax consequences related to repatriation). As I stated previously, it's not buyback vs. dividend - the company could easily employ both strategies.

AAPL currently trades at about 11X its estimate for this fiscal year ending in September 2012. One has to wonder if it gets any credit for the roughly $80 per share of cash and investments net of debt and deferred revenue. If the company were to return a bunch of cash to shareholders through a large dividend, many would be burdened by tax consequences. It seems likely that the stock would rally over time after it went ex-dividend (to the extent the stock trades on PE with investors not factoring in cash), so all shareholders would benefit, at least to some extent.

On the other hand, if AAPL were to spend 1/4 of the cash repurchasing stock at say $400, it would reduce sharecount rather dramatically. $19 billion would buy 47.5mm shares, reducing share-count by 5%. Of course, this would have minimal impact on net income since the cash isn't earning much interest, so EPS would rise by approximately 5%. I think its safe to assume that the stock would rise 5% as well, benefiting the remaining shareholders, but that's not really the way to look at it from the company's perspective. They are making an investment in AAPL stock. If earnings never grow, they are getting a 9% earnings yield (the 11PE inverted). Is this better than holding cash? It all depends on future earnings as well as other factors. If earnings continue to grow, it will ultimately look wise, while if the business crumbles, it won't. If a better use of the money comes along, like 20% interest rates or the chance to make an acquisition at 5PE, it won't look so smart. These seem unlikely. Given how over-capitalized the company is (they spend just $2 billion annually typically on capital expenditures and have spent <$1.1 billion in acquisitions over the past decade), I can't imagine a better way to spend the money given the current low valuation.

Generating Massive Cashflow - Johnson & Johnson

All the troubles that Johnson & Johnson (NYSE:JNJ), which I include in my Conservative Growth/Balanced Model Portfolio, has faced (consumer recalls, patent expirations, slowing demand in its medical device markets) haven't stopped it from generating tons of cash. Despite a generous dividend payment and vigorous M&A activity, the company can't stop the coffers from overflowing. Already in 2011, the company has generated net income of $9.4 billion through the first 3 quarters. As is typical, free cash flow is a bit higher as capex typically runs a bit below D&A. So, YTD, FCF is equal to about $10 billion. The company has paid $4.6 billion in dividends and closed $2.5 billion in acquisitions. So far, it has repurchased $1.7 billion in stock. Cash balances have increased by a little more than debt, leaving the balance sheet with about $12 billion net cash.

Through its share repurchase program, JNJ has been able to more than offset equity compensation-related dilution, as the share-count has fallen modestly each year. While it might be easy to say that JNJ, which is locked in a sideways pattern now for almost a decade as its PE has compressed from 30 to 13, has "failed" to boost the price, I don't believe that this ex-post analysis is fair. The share repurchases have increased in recent years compared to earlier in the decade. I only wonder why they aren't more aggressive now. Given how inexpensive debt capital is for the company given its AAA rating, it seems like JNJ should be a bit more aggressive in reducing the share-count.

JNJ, then, has a pretty balanced approach to allocating capital, with the bulk of the FCF going to dividend payments. If the stock were trading at 20 PE, I might question their practices of repurchasing stock, but the earnings yield is almost 8% for a company that can issue 10-year debt below 3%. Buying the stock looks smart to me.


Not all buybacks make sense. The good analyst tries to understand the thinking that goes into how companies go about allocating capital. The key to every decision is to understand the potential return on investment to the cost of capital (or the opportunity cost). Cost of capital, by the way, doesn't mean the current yield on cash. Just like a company can overpay for an acquisition, it can overpay for its own stock.

While this happens often, sometimes a share repurchase can be the best use of capital. Even if the stock declines after a company repurchases it, it's not always a "mistake" to have bought the stock before it declines (just a bad outcome). It can be that the stock would have declined even more if the share-count hadn't been reduced. Plus, the ultimate judgment should be over a period of several years. The smartest repurchases are ones that can be expected to return more over the long-term than external purchases or investments. They shouldn't constrain reinvestment in the business either, but the same can be said for high-payout dividends.

In this environment of extremely low borrowing costs and low equity valuations, I think that it makes sense for companies to consume cash and to use debt prudently to reduce their own share-count. I have seen many examples of companies capable of generating relatively stable free cash flows using moderate amounts of debt (or depleting excess cash). While it's easy to find stupid share repurchases from 2006 and 2007, I expect that many of those from 2011 will look brilliant over the next 3-5 years.

Disclosure: I am long JNJ in a model at Invest By Model