When Buybacks Are Bad

As investors, we're conditioned to believe that the announcement of share buybacks is good news for a company. After all, such an announcement represents management's confidence in the fact that the share price is undervalued, and nobody knows the business better than management. For some shareholder groups, buybacks offer a tax advantage that dividends do not. While these arguments are almost always completely accepted by shareholders, the investor must consider the fact that management and shareholder interests do not always align (as discussed here), resulting in a great deal of cases where buybacks actually destroy shareholder value rather than create it.

Consider a company which pays its management in stock options (indeed it is rare not to find such a company today). If management were to pay a dividend, shareholders would receive cash, but the value of management's options would drop. (For an explanation of this phenomenon, see this discussion.) On the other hand, when a company buys back and cancels its own shares, each share ends up owning a proportionately larger amount of the company, which can result in an increase in the value of an option. Management may have no malicious intent, yet it is nevertheless impossible for their actions to be completely detached from their personal well-being.

Stock options aside, managements are in their positions because of their abilities in running the operations of the business. They are not experts at capital allocation, nor are they good predictors in the field of macroeconomics. Yet when they buy back shares, they are implying that they can allocate capital better than shareholders. Rather than give the cash to the shareholder, at which point the shareholder can decide what's best for himself, management has made this decision for him.

As an example, here is a look at the dividends and buybacks of the last four quarters for some of America's most prominent retailers. The dividends are small, but the buybacks are enormous. Unfortunately, investors would have been much better off with the cash in their hands. The chart shows what the dividend yield would have been had the money used for buybacks been paid out. It also shows the average price at which companies bought back shares, and compares it to their current price:

Each of these companies save for Wal-Mart (NYSE: WMT) paid significant premiums over the stock price. In the case of Home Depot (NYSE: HD), had they paid out the cash used in their buybacks, the dividend yield would have represented a staggering 30% of the current stock price. Certainly, this dividend represented a one-time outlay and is not sustainable, but it would have represented a shareholder-friendly action from a company looking to regain shareholder confidence after a difficult few years.

All of the companies listed above save for Wal-Mart wasted great opportunities to put funds in the pockets of their shareholders. Rather than try to value the shares of their employers, or predict where the economy is going, management should focus on its operations and direct its free cash flow into the hands of shareholders.

Disclosure: The author has a long position in BBY and HD

Comments

[jimmy46:]

Stock options tend to corrupt management in many ways,
and the claim that they align interests is not true.

Estate advisors tell exec's to sell the stock and THEY DO.

Chapter 7, Options, in the book "THE NUMBER" BY BERENSON
is a must read for all stockholders.

Options corrupt, and stock options corrupt absolutely.

2008 Aug 05 02:50 PM

[tipalia:]

shares buybacks are ok for the small investors,but ok only,and they are GREAT for the big fat cats taking all the decisions. if they had the best interest of their shareholders in mind(like they are obligated or are they?) special dividends or raise the dividends is the only route.
but once again greed is the name of the game for those fat executives. it has been like that always and will continue forever.
Since stock options have been created it s nothing but a source of corruption,abolish it completely and bring some sanity back in the system.

2008 Aug 06 09:03 AM

[BlueOkie:]

Companies can invest, buyback shares or increase dividends. Each has its pro's and con's. If share buybacks exceed options issued then I see a positive for the shareholder. This is compensation and I would think many exec's would prefer then money vs options.

2008 Aug 06 10:06 AM

[Glenn Alperin:]

I really don't understand the logic about why stock options are supposed to be good for a company. I understand that it makes it more attractive to keep supposedly qualified and profit-driven executives, but since when should those executives get to keep the milk money from a cash cow when they are not rewarding their employees adequately for a job well done? I worked in retail for about 7 years, and if management didn't have us underlings to actually do the grunt work, there is no way the companies I worked for would have made the money they made to be able to afford to pay the management at the top so excessively, whether that is in cash or stock options. I'm all in favor of returning that money to the stock holders by way of dividends, but here is an even better idea? Why not return it to the hourly employees who worked their butts off in the first place? It sure would be a marvelous tool for keeping at bay one of the biggest expenses in running a retail business: employee turnover.

Right. Time to get my head out of my ass again and return to reality. Management doesn't care about employees as anything other than a line which they would prefer to be dispensable on the expense reports. For the most part, they don't care about their stockholders either. I wish you luck trying to change the corporate culture of such companies. You'll need it.

2008 Aug 09 01:38 AM

[Saj Karsan:]

Hey Miser,

Unfortunately hourly wages are a huge part of a retailers costs, and so retailers always look for ways to reduce them (one growing example: self-checkout kiosks). This creates better paying jobs in the tech industry; the side effect is it reduces the requirement for hourly floor employees.

If a retailer serving the masses could make money paying its hourly workers substantially more (to reduce turnover as you suggest), then we will see such a retailer steal share from the likes of Walmart, Home Depot etc., but it appears unlikely.

2008 Aug 09 12:23 PM