By Eric Ervin, Co-Founder and CEO, Reality Shares
Remember "Peak oil?" The Exxon Mobil (NYSE:XOM) board probably does. On February 2, 2016, the company announced that it would cease its voracious stock buyback program as profits hit their lowest point in over a decade. Indeed, over the course of the last decade, XOM spent over $210 billion on stock buybacks. However, the company reiterated its commitment to its dividend policy. This dedication to dividends and dividend growth is what sets good companies apart from the pack, in good and bad times. But the dedication to buybacks is another matter completely. In fact, the question is constantly asked: "who really benefits from buybacks?"
Last August, Reality Shares authored an article in TheStreet.com which presented the results of a study we did that revealed stock buybacks have a rather poor record when it comes to adding any real value to company performance. In the article we discussed the four ways that companies use their free cash: 1) invest in organic growth; 2) accretive growth through acquisitions or investing in other companies; 3) paying down debt; 4) stock buybacks and dividends. All but the stock buybacks are intuitive and that begs the question: why did XOM spend an average of $22 billion on repurchases per buyback period since 2000?
How did that "investment" of close to a quarter trillion dollars benefit the company and its shareholders? From August 2000 through December 2015, XOM had 12 distinct buyback periods and repurchased nearly 4 billion shares. Comparing the average repurchase price in each of these periods with the period-end and 2015 year-end closing prices for XOM, the company overpaid on a per-share basis 83% of the time (in 10 of 12 buyback periods).
For years, shareholders and analysts have been asking the same thing about the real value of buybacks. Why is it that most uses of company cash for investments require a measurable ROI justification and buybacks do not? What kinds of factors are considered when executives make the decision to spend a company's precious cash to buy back its own shares?
Yes, share buybacks can provide a short term bump in stock price and put some lipstick on EPS, but studies like the one done by Reality Shares have not provided any compelling long term relationship between buybacks and stock price performance. Most cynics would say that a buyback program has something to do with executive pay…. and that is partially true. However, as with most things financial, a single sentence explanation is not sufficient.
In a study done by University of Chicago's Booth School of Business, it made the point that: "in the late 1990s, the use of employee stock options increased dramatically, as did the use of stock repurchases." Importantly, it turns out that both affect a company's earnings per share (EPS). As new executive pay programs became more performance based, the use of stock options in lieu of salary has greatly increased to the point that today only about 20% of top executive pay is made up of salary!
The issue is a large amount of incentive options dilutes existing stock. An expanding share base without the offsetting income will reduce the EPS, a key metric used in most C-level incentive pay programs. So, would it be too cynical to think that management would decide to buy back shares to reduce the float and make EPS look better? The most glaring thing about stock repurchases is the following: why not reward the stockholders with dividend growth as they are the ones who take the risk?
It's not surprising that numerous articles have suggested that managers repurchase shares to offset EPS dilution in response to employee stock option plan dilution, and some executives have acknowledged that their decisions to issue and repurchase shares have been influenced by potential EPS effects. By reducing the number of their shares on the market, companies beef up their stock's price, which they believe to be undervalued. And fewer shares translates to a lower denominator in measuring EPS.
In fact, the cited University of Chicago study showed that while repurchases may provide a temporary boost to EPS, it "does not create any value for shareholders." And what is the mandate for company boards and managers? Answer: create shareholder value.
Think about it: XOM spent close to one quarter of a trillion dollars on stock repurchases in the last decade instead of rewarding shareholders or allocating it to other ROI related investments. Management apparently chose to feather their own nest, aided and abetted by the board. What would a quarter of a trillion dollars' worth of dividends have done for the total return for XOM shareholders'?
If any topic should help motivate more shareholder activism, it should be to change company policies regarding the use of free cash when it comes to rewarding employees and diluting stock or rewarding shareholders with dividend growth. In the case of Exxon Mobil, the opportunity cost to shareholders has been staggering.
This article represents the opinion of the author and may not represent the opinion of Reality Shares.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.