There are no absolutes with company share buybacks
April 8th, 2014

Is there a good reason for a company to buy its shares back on the open market and record as treasury stock on the balance sheet (buyback)? It would be nice if there were a straight answer.

Life is 100 percent, but absolute right and wrong represents only 10 percent each. The other 80 percent is uncertainty. I will say “yes and no” and delve into the 80 percent. When the company says “our company is the best thing out there to invest in,” it, at minimum, is a very interesting statement.

Some options management has and points of interest:

Immediately, the risk is low in a buyback, compared with the other options. But remember the risk/reward ratio. The lower the risk, the lower the return -- and vice versa. It is not nearly as much work to make the buyback succeed as it would be for the other options to succeed.

Timing is an issue with any of these options.

No matter how good the due diligence and market research concerning the other options, they carry much higher risks (integrating cultures and processes or battling the competitors on new products, etc.).

Is a buyback an investment or a way to manage outstanding shares to help manage a higher earnings per share? Obviously, getting a higher EPS is very important, as that is what basic fundamental stock analysis is looking for. It is a way to give some value back to shareholders by dividing the same amount of profit with fewer shares.

There is no return on investment calculation on a buyback because it generates no income or cash flow whatsoever, but cash is going out the door.

Management’s objective is to maximize shareholders wealth. So giving back to the shareholders is a good thing, but long-term growth in the business itself will maximize shareholders’ wealth. Somewhere in the long term, you must hope the company can do strategic initiatives to help the profit/income increase. In the short term, buybacks are good, but with no profit growth it will have negative effects if competitors invest in their future.

Some points of interest:

1. When a company’s stock options have been exercised, causing an increase in outstanding shares, a buyback is a very useful management tool to help keep EPS dilution to a minimum.

2. For shareholders, there can be some tax advantages to a buyback versus paying a straight cash dividend. (Consult with your tax adviser). Also, if the company needed the cash-flow later, it does not have to rescind the dividend, which could have a negative effect on the stock price.

3. A windfall of a buyback is the increase of return on assets and equity ratios -- although you do not want this to be the reason management does a buyback.

4. Some argue that buybacks unleash the hidden value of the stock.

Some things to keep in mind when the company says, “Our company is the best thing out there to invest in”:

1. Buybacks are an important tool to management but are not all-encompassing.

2. Where are other opportunities to grow the business?

3. Would you buy the stock at current levels?

4. Understand the motives of management.

5. Not propping up ratios (e.g. ROE and ROA).

6. Make sure no debt is in the buyback.

There is no absolute right or wrong answer, but find a reasonable point where resources can be allocated to maximize shareholder wealth.

It can seem like throwing money away when the stock price is high, since the basic objective is to reduce outstanding shares. You can either buy back more shares at a lower price or just not spend as much money and get the same number of shares. The buying pattern of the buyback is important to ensure proper utilization of company resources.

Most companies do allocate dollars for buybacks. The buyback should be part of their overall resource management but ultimately, the companies should always be looking to grow the business and stay competitive in the market they serve.

Here is some history of a very reputable technology company from its website. It shows the company bought on the high side 13 of 17 years (negative). Note that three of four positive years were in the technology bubble years and then in 2013, years when stock prices were rising.

Have a question or a company you'd like me to take a look at? Email me atbrent@wilseyassetmanagement.com.

Wilsey is president of Wilsey Asset Management and can be heard at 8 a.m. every Saturday on KFMB AM760. Information is provided by Reuters.

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