One event to look forward to as a bank investor is the regular announcement of the company's capital allocation plan. This usually gives an idea as to what the dividend payment will be and what the share repurchase program might look like.
When this sort of news comes out, there are a couple of adjustments to make. For one thing, the per share dividend gives you an indication of what you might expect income-wise in the year to come - you can start making cash flow projections with a great deal of accuracy. And on the share repurchase front, a favorite thing to do is to start to calculate what percent of the company might be retired in the coming year.
Yet unlike the dividend, the share repurchase portion tends to be a whole lot more unpredictable. There are factors at play that go beyond the headline number or share count indication. I'll give you an example using Wells Fargo (NYSE:WFC).
Notably, the capital allocation headline for Wells Fargo does not usually provide a specific share repurchase dollar amount like many of the other banks, although a given number of shares is periodically mentioned. Regardless, you're about to see why it can make sense to substantially discount this expectation.
On January 13th Wells Fargo announced fourth quarter earnings. What I'd like to turn your attention to is the 9th slide in the deck , "Balance Sheet and credit overview:"
As you scan through the slide you can make note of things like loans being up, trading assets are down, long-term debt is up, short-term borrowings are down and that sort of thing.
And then there's this shout out to common shares outstanding:
From first glance you might think this is reasonable enough. Wells Fargo spent a lot of money buying out past partners, retiring shares along the way. That's part of the capital return package that you have come to expect. Yet when you stop and look at it, the numbers should be a bit off-putting.
During the fourth quarter of 2016, shares of Wells Fargo traded hands anywhere from $43 to $58. When you divide out $1.1 billion by 7.8 million shares you get an average price of $141 - magnitudes higher than anything that the market has ever offered.
So what's going on here? Good question. The answer is provided on slide 26 of the presentation:
You can see that Wells Fargo not only purchased shares, it also issued quite a few shares: the business bought back 24.9 million shares, but then issued 17.1 million shares. (Not necessarily in that order, but that's an easy way to think about it.)
Let's consider this in terms of the net effect. Suppose Wells Fargo purchased those 24.9 million shares at an average price of $50 (the 10-K doesn't come out until later). This translates to a cost of $1.245 billion - which by itself would be a solid reduction. However, once combined with the issuance it isn't so endearing.
In order to get back down to a $1.1 billion cost, that's ~$145 million in net issuance proceeds that would have to be received. That sounds like a lot of money, but it's not in comparison to the 17.1 million shares issued. In effect, you could think about it as buying 24.9 million shares at $50 and issuing 17.1 million at $8.50.
Now to be sure this is linked to compensation - which could be argued as a fine incentive for employees. Yet it's still a staggering difference. You can look at it as buying at $50 and selling (mostly giving) at $8.50 to get to the difference or else retiring shares at an average price of $141. Regardless, the appeal is far less than what you might read from a headline number.
Interestingly, the company has already set itself up for this same sort of thing next quarter. In the second bullet point from above Wells Fargo announces that it has entered into a $750 million repurchase program for 14.7 million shares. That equates to an average price of about $51 - which would be perfectly fine news for those that believe the current price offers a fair or better value proposition.
However, it does not yet mention the issuance side. In all likelihood it won't be the end of the story. Come Q1 of 2017, the same dilution in the net benefit will likely take hold. And this happens over and over again - it's not just an isolated incident.
In the third quarter, Wells Fargo reported that the share count had declined by 24.6 million on net repurchases of $1.3 billion. A total of 38.3 million common shares were repurchased, but 13.7 million were issued.
In the second quarter, the company reported that the share count had declined by 27.4 million on net repurchases of $1.3 billion. A total of 44.8 million common shares were repurchased and 17.4 million were issued.
In the first quarter, Wells Fargo highlighted that the share count had decreased by 16.2 million shares on $1.1 billion in net repurchases. A total of 51.7 million shares were repurchased and 35.5 million were issued.
Tally it up and over the past four quarters Wells Fargo has stated that the share count has been reduced by 76 million shares on net repurchases of $4.8 billion. You could think about it in a couple of ways. For one, that equates to an average retirement price of about $63 - a price where the share price has never been on the market.
Or you could think about it as the company repurchasing 159.7 million shares, but simultaneously issuing 83.7 million shares along the way. If the average repurchasing price happened to be $50, that'd concurrently require an average issuance price of about $38.
Some quarters are better than others, but this dilutive factor is always a consideration.
Now none of this is to suggest that Wells Fargo can't be a fine investment. The company has 5 billion common shares outstanding, so we're talking about quantities in the 2% to 3% range of the total. Future earnings growth, customer relationships, balance sheet strength, interest rates, regulation and a host of other factors are apt to play a larger role in the overall equation. Moreover, there's an argument to be made that while dilutive, this type of ongoing issuance can ultimately prove beneficial should it mean retaining and developing incentivized employees.
Still, I'd contend that this is good information to keep in the back of your mind. When you're coming up with expectations about the business and security (and specifically the capital return program), personally I would substantially discount the share repurchase portion. It could add a bit of benefit, but history shows that the "net effect" both in numbers and in pricing, is apt to ultimately be less impressive than it first appears.
Disclosure: I am/we are long WFC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.