Dec

16

After thinking about buybacks, here are some observations.

1. In 2003 companies were given safe harbor from being accused of manipulating their own share prices so long as they had a proper share repurchasing plan. In 2004 they were double the dollar value of 2003, and by 2007 total dollars on repurchases had grown 7 fold to its peak (2012 is still nearly 5 times the 2003 figure).

2. Companies buying back their shares are reducing 3% of their shares outstanding, and it is supposed to be more than 4% reduction next year.

3. There is clear evidence for firm specific seasonality of buybacks. One example: In the fourth quarter, AutoZone (AZO), repurchases more than twice the average of the previous 3 quarters, and they do this every year. This is because the 4th is their highest earning quarter, and they want to finish the year with an EPS growth bang.

4. Be watchful of firms that have large buyback plans, and executive compensation based only on share price and EPS. AutoZone goes on and on about operational efficiency, and new loan facilities for general operations; its completely obvious that most of the debt is for repurchases, and the EPS growth is mostly from those repurchases. They never put it center stage…why?

5. The SEC sees using repurchases to "manipulate" earnings as a violation of the law, while at the same safe harbor can be obtained relating to price manipulation. How they separate the two is baffling; "manipulation" is dangerously vague, and many firms may get aggressive at their own peril.

6. Treasury shares are not the only place shares can go to. A very dubious dark hole on a balance sheet: The SEC interprets the law as shares repurchased do not have to be shown in treasury shares, disclosed on the balance sheet, or earnings statement.

7. From the SEC website, "Rule 13d-1(a): In calculating the number of outstanding shares, shares repurchased by the issuer to fund a stock option plan are not considered to be outstanding even if the shares are not retired or put in treasury. Section 13(d)(4) of the Exchange Act provides that the class of outstanding shares will not include shares "held by or for the account of the issuer".

8. This doesn't only apply to shares repurchased for stock option plans. Here is another from the SEC website:

9. "Shares that an issuer repurchased do not count as outstanding shares, even if the issuer did not retire the shares or account for them as treasury stock. Section 13(d)(4) of the Exchange Act excludes shares "held by or for the account of the issuer or a subsidiary of the issuer" from the class of outstanding shares. [Sep. 14, 2009]"

10. Looking at AutoZone's total share repurchases, it's easy to tease out that they repurchased over 500,000 shares from their stock option programs over the last year. That number is hidden though, because their repurchasing program is so large. The company essentially spent around 250M dollars repurchasing shares from executive compensation. You can't get that number from the balance sheet, income sheet, or other filings (I've looked very hard at this company).

11. It is supposed to be more difficult to re-float shares without notifying shareholders, or getting approval, since NYSE got rid of the "treasury share exclusion". However, if the shares are hidden away in a compensation plan which had been "approved" by shareholders those shares can float. Example next.

12. Again, picking on AZO, because that is who I know well: They have multiple compensation plans and there might be around 26% of their total market cap tucked away in various share programs. You have to look very close in multiple filings over time to get a picture of it.

13. The IRS recognizes the cost of compensation with the options are actually executed: if a repurchase plan pushes shares high enough over the period of years until the are executed, the company can write up the cost of compensation and recognize the cash flow from taxes in the current period. If you push up the stock price enough, you can recapture all of your executive compensation "costs" (cost of dubious option valuations, see next) in cash flow from taxes in future quarters. In 2011, AZO received 6% of their net profits was equivalently this cash flow.

14. It seems unlikely that any company values their stock options for compensation under the consideration that the company will be buying back half of all outstanding shares over the next 3, 4, or 5 years. Think of the firm which has given the executive suite only two targets, EPS and share price, while authorized a repurchase plan large enough to hit those targets on their own. It is not a stretch of the imagination that regulators could come to the conclusion that companies are understating that they can, and do, affect their share price.

Therefore, the economic benefit of the option award is not only more in dollar value (above the strike) than what was recorded as cost of compensation, but it is more likely to be executed than what was input into option valuations. The result could be seen as an intentional understating of the cost of compensation, while using buybacks to guarantee management targets are hit, options are awarded, and exercised well into the money.

15. Firms that repurchase their shares, as a whole, are outperforming market capitalization indexes partially because when their stock prices increase, the change will be larger than the change in market capitalization by basic math. Look at AZO, which has seen its share price grow over 5 fold, while their market cap little more than doubled over that same time period.

16. Likewise, if demand for some equities is partially, or entirely, being met by issuance of shares, those firms will increase in market cap more than than their share price.

17. Many companies are supplementing, or forgoing on dividend programs with buybacks

18. Following that logic, "Dividend stocks" as an asset class might need a modernization; depending on the truth value of the previous two claims.

19. A company can avoid "diluting operations" by pursuing buybacks; as opposed to the core operation's impact on the bottom line being watered down by chasing capital investments, or acquisitions with decreasing marginal returns. I haven't heard anything about this point of view.

20. Seemingly valid EMH critique: "In the longer run, a relative reduction in reinvestment, new investment forgone, or both, should result in a relative reduction in future returns, which in turn should relatively reduce the value of shares". This is true, if the expectation has to be that the returns foregone are of greater magnitude than the reduction in shares outstanding. It's easy to see that 10% less earnings over 11% less shares is relatively better for the people still holding their shares.

21. Additionally, humans, and many other living creatures, discount the future exponentially, or hyperbolically. We'll discount the potential longer run costs of substantial share repurchases if those repurchases are timely and of a magnitude into the future to negate the discounted opportunity cost.

22. If buybacks are accelerating and are not disclosed until each company's the quarterly reports, how are major indexes keeping up with that data, and why is this not an opportunity to get in front of ETF and other index matching funds (some funds rebalance annually)?

23. The opposite works for loss making firms: A company can give a positive trend in negative EPS simply by floating more shares. -$10 per share turns to -$8 per share simply by floating 25% more shares. Firms like this may appear to be on a positive EPS trend, while doing it a "cheaper" price.


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