Playing Share Buybacks

Includes: PFE, TRIB
by: Wexboy

Ideally, I’m a supporter of share buybacks, but in the cold light of day I have very mixed feelings about them. The quality of stock and buyback analysis in most companies is atrocious – throw away your corporate finance textbooks! I don’t think I’ve ever met anybody who could arrive at (or coherently discuss) a fundamental intrinsic value for their company stock. This is a tremendous handicap for any kind of strategic decision making. For share buybacks, the usual analysis goes something like this: Do we have spare cash/debt for a buyback? Are we feeling good about the company, the share price, ourselves? What’s the EPS impact? This impact is usually the trigger for a share buyback. I’m certainly not singling them out for negative comment, but I’ve written recently about Trinity Biotech (TRIB) so let’s use their numbers as an example:

TRIB has an annual net income run-rate of $15.74 million, corresponding to a basic EPS of $0.739 (based on 21.298 mio weighted average ADRs). With plenty of cash on hand, let’s assume TRIB launches a $25 mio buyback. It picks up 2.569 mio ADRs at $9.73 per share. All other things being equal, TRIB’s net income in the following year will be slightly lower at $15.088 mio due to reduced financial income. But based on the new share count, EPS will magically increase to $0.806 per ADR! A 9% EPS increase is a colossal assist for any company in beating internal/external targets and, of course, in boosting the share price.

And that’s it, there’s nothing more behind the curtain! There’s generally no attempt to determine intrinsic value, or to buy at an attractive discount to this value. This mechanical approach is the main quantitative driver for share buybacks. Of course, the EPS impact depends on a number of facts/assumptions: cost of debt, your buyback price, your tax rate etc. But that’s very easy to deal with – just create some assumption grids, review with your CFO, and agree strategy accordingly ...

What about the more qualitative aspects? I wasn’t joking when I posed the "Are we feeling good?" question above. Companies, and their executives, are notorious for unleashing giant/hubristic buybacks just when their share prices are peaking. There are some good studies out there on this. And I’ve experienced this personally. To my chagrin, I’ve bought back tens of millions of shares at prices far in excess of today’s price. Just following orders, your honor! Adding insult to injury for long suffering shareholders, the buyback was discontinued shortly after the share price peaked. And the company’s never bought back a single share since, despite the long slow slide in the share price. "Buy high" is a very common story. On the other hand, "buy low" seems to be a much less familiar corporate motto - where were the big share buybacks in 2008?!

Then there’s the more unsavory aspect: personal greed. Compensation and incentives are so lucrative these days, and so biased to raising EPS and share price, that buybacks are incredibly tempting for executives. This leads to an unhealthy bias towards buybacks, sometimes to the detriment of dividend growth and/or longer term shareholder value. Another form of abuse is the use of valuable company cash to buyback shares in an attempt to offset the market impact of previous management decisions/disasters.

And once a buyback is complete, are the shares cancelled immediately? If not, what happens? A reduction in equity is logical, but on occasion I’ve seen shares carried on the balance sheet rather bizarrely as an Asset! No matter the treatment, one should treat these shares as cancelled for analytic purposes. It may take some digging around, but the best thing to focus on is net outstanding shares, not issued shares, to arrive at the correct share count.

What’s really problematic are the companies who don’t actually cancel bought back shares. This is sheer corporate arrogance, and poor governance. Take a look at the latest 10K from Pfizer (PFE): They’ve now reached a total of 864 million repurchased shares, none of which have ever been cancelled. This is ludicrous, and there are many other Fortune 500 examples out there! Why on earth do executives think they have the right to potentially reissue/sell these shares? Having this type of "back-up kitty" on hand just leads to flabby decision making. The one exception I’m comfortable with is investment companies with un-cancelled shares, as long as they only re-issue/sell these shares above NAV. Of course, this points to the real issue: regular companies have no true underlying NAV to rely on when evaluating share buyback activity. This presents a real problem. If you don’t even venture a guess at an intrinsic value for your stock, how can you figure out if a share buyback’s at a discount and adding economic value for your shareholders? A mechanical EPS impact analysis certainly isn’t going to help you.

Let’s review Trinity Biotech again, from another perspective. In a previous article, I highlighted TRIB is currently on a 2.6 price/sales multiple. I believe that a 3.5 P/S multiple is more appropriate based on recent M&A multiples achieved for medical device/diagnostic companies. This puts my intrinsic value estimate at $13.25, based on 21.227 mio ADRs outstanding. This time around, let’s assume TRIB executes a successful $71.1 mio (total cash on hand) tender offer at $11.19, a 15% premium to the current share price. This would retire 6.356 mio ADRs. Now where do they stand? Interestingly, Revenue and Operating Margins remain unchanged, while their balance sheet remains debt free. I would therefore argue they’d still achieve a 3.6 P/S multiple in a takeout situation, but now we only have 14.871 mio ADRs outstanding. So TRIB shareholders would actually realize $18.91 per ADR, far higher than my intrinsic value estimate prior to the tender. Remember, this is a simplified example, but you get the idea!

The key to this uplift in value was the aggressive purchase of shares at a significant discount to intrinsic value. Departing shareholders are (unknowingly) selling out at a poor price, while remaining shareholders get to enjoy a larger slice of the pie. When I’m evaluating a company, I don’t necessarily know what motivated management to launch a buyback program or how much they truly care about shareholder value. But there’s no real need! Once I calculate my own intrinsic value for the company, I can determine whether buybacks are at a discount to this Value and genuinely creating shareholder value. Once I see this with a company I own, or that’s on my buy list, I’m all for share buybacks – the more the merrier!

Disclosure: I am long TRIB.