Many Sirius XM (SIRI) investors are anxiously awaiting a resolution to the stand-off with Liberty Media (LMCA), the company's largest shareowner. The hope is that once the uncertainty surrounding the future of the company is cleared up and a share repurchase program begins, the true potential of the company will be reflected in the share price and investors will see the value of their asset rapidly appreciate. Is this optimistic view justified?
A corporation repurchasing its own stock does NOT increase the "intrinsic" value of the company. If Sirius XM buys back its own shares, it does not increase sales, cut costs or decrease debt. It takes cash that could have been reinvested in the company to develop future growth opportunities and uses that cash to buy back its own shares. Arguably, the value is reduced with cash removed from the balance sheet. If that's the case, why do companies repurchase their own shares? And, why did S&P 500 companies repurchase $2.7 trillion of their own shares between 2004 and 2011 while only paying out $1.8 trillion in dividends?
One reason might be that companies want to get cash off their books to make them less attractive as takeover candidates. It is easy to see how this idea could come into play with Sirius XM and Liberty. At some point it appears fairly certain that Liberty goes to a majority ownership position of Sirius XM and installs a pro-Liberty board. At that point, Liberty can use the Sirius XM cash to repurchase the shares used to get to a majority position. (Note that these would not be the preferred shares, would have a relatively high cost basis and minimal tax implications.) This hypothetical scenario allows Liberty to recover the cash expended in 2012 to take over Sirius XM.
Another reason frequently seen in SEC filings is to offset dilution caused by the issuance of new shares for stock based compensation plans. A recent report from Credit Suisse notes several companies, including Apple (NASDAQ:AAPL), AutoDesk (NASDAQ:ADSK), eBay (NASDAQ:EBAY) and United Healthcare (NYSE:UNH), that specifically reference one purpose of the buybacks was to offset this type of dilution. Sirius XM investors have been watching CEO Mel Karmazin exercising 60 million options and it is likely he will eventually be converting 120 million options into newly issued shares.
And it's not just Karmazin's options. According to the Sirius XM first quarter 8K, there were more than 400 million common stock equivalents excluded from the company's more than 6.5 billion diluted share count. Even with aggressive share buybacks, it will take a fairly long time and billions of dollars to make a big dent in the company's nearly 7 billion shares.
Aside from reversing the effects of dilution, why do companies choose to announce and implement buybacks to return capital to shareholders as opposed to paying out dividends? There are many reasons, including:
- Dividends, once announced, represent an ongoing commitment to make the payments to shareholders. Karmazin has expressed a concern about shares being punished in the market if/when revenue or earnings forecasts are missed. Well, when dividends are cut or discontinued, share prices also take a beating.
- Share buybacks are typically an announcement and not a commitment to actually spend the specific dollar amount. In some cases companies give a specific time frame, but after the announcement and a short term pop in the price, investors tend to forget about the buybacks until the amounts are reported as part of the future earnings releases.
- Tax treatment. To the extent that a share repurchase results in capital appreciation, a long term gain has historically had preferential tax treatment while dividends had been treated as ordinary income. The Bush tax cuts, which have been extended until the end of this year, removed some of that preferential treatment and "qualified" dividends currently also benefit from low tax rates. It is not clear whether the current special treatment of dividends will be extended.
And, of course the big reason many investors cheer buybacks is the potential for increased earnings per share. As the number of shares decline, each share is allocated a greater share of the earnings. So, what tends to go wrong with buybacks?
Companies tend to build up cash in good times - the same time that the company is doing well and share prices are high. The Credit Suisse report cited above examined the S&P 500 companies over an eight year period. The study approached share buybacks as an investment option and found the following:
There are 306 companies or 61% showing a positive return, 154 companies or 31% with a negative return and 40 companies that had no buybacks over the past eight years. But if you were to benchmark against a cost of equity of let's say 7%, we find only 180 companies or 36% that beat the benchmark. As a result it looks like most of the buybacks for the S&P 500 over the past eight years have not yet added much value for the remaining shareholders.
These findings are not inconsistent with prior data. In a previous article, I wrote:
"TrimTabs Investment Research estimates that companies that announce buybacks outperform the market by 0.7 percent the next day, and by 1.2 percent in the first 100 days." However, Birinyi analyst Rob Leiphart notes that the stock of S&P 500 companies that did not announce buybacks in 2010 actually performed better than those that did.
Share repurchases have a checkered past, with companies often overpaying for shares and investors frequently seeing little benefit. Does this mean that a share buyback won't drive the price of Sirius XM shares higher? Not at all, but it does indicate that a share repurchase may not meet the lofty expectations of some Sirius bulls.
The Credit Suisse report focused on repurchasing shares when they are below their intrinsic value:
The concept is pretty straightforward, if a company pays less than intrinsic value when buying back its stock value is added for the remaining shareholders since wealth is transferred to them from the selling shareholders (that's what happens when you pay $0.80 for a dollar). On the other hand if the company is paying more than intrinsic value that destroys value for the remaining shareholders who transferred wealth to the former shareholders (or as Warren Buffet noted in the 1999 Berkshire Hathaway Chairman's Letter, "buying dollar bills for $1.10 is not good business for those who stick around"). If the company pays intrinsic value for the shares (efficient market) its value neutral for the remaining shareholders since no wealth is transferred.
Part 2 will look more closely at cash available for share repurchase programs, potential earnings and free cash flow per share, and potential share price appreciation.