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Borrow Money To Buyback Stock?

6 July 2010 No Comment

To the average person, this might seem like it violates common sense, but this is a fairly common move for public companies.  Fidelity National Information Services (FIS) is the latest company to do this – Fidelity is selling $1.2 billion in debt to help fund a $2.5 billion buyback in company stock.  The move shows that management believes they can get a larger return on their own stock versus the cost of servicing the $1.2 billion in debt.  This is usually perceived as a bullish move since obviously management has confidence in the future of the company, but as an investor, I don’t love the move.

As I’ve noted recently, buybacks are gaining momentum due to a major increase in corporate profits.  Buybacks may be attractive for investors, but economists have hoped the corporate profits would lead more to job creation than investor returns.

Buybacks Gone Wrong

Share buybacks can often go wrong – just take a look at companies that bought back billions in their own stock in 2007 (for example, Macy’s (M) bought back $3.3 billion in 2007 which ended up being a terrible investment).  If they can go wrong, then borrowing money to fund a buyback is especially dangerous.

For the largest example of a failed buyback, consider BP’s (BP) actions since 2005.  BusinessWeek reports that BP bought back $37 billion in shares between 2005 and 2008.  With the recent Gulf oil disaster, BP stock has been pummeled.  The shares that were bought back are now worth approximately $15 billion excluding dividends.  Even worse, BP desperately needs the cash to pay for spill-related costs.  If BP would have instead returned cash to shareholders in the form of dividends, and kept higher levels of cash, they would be in much better shape and investors would have had larger returns.

Why Do Companies Do Buybacks?

On the surface, companies buying back stock seems like a great idea since it decreases the number of outstanding shares which means your stake in the company is essentially more valuable as a result.  Let’s look at the reasons companies initiate share buybacks:

  • Buybacks reduce assets on the balance sheet which improves certain financial ratios.  Cash and equity decreases which increases ratios such as ROA (return on assets)  & ROE (return on equity).
  • P/E ratio also improves since EPS increases as a result of decreasing number of shares.
  • Possible higher return on investments – as discussed above, management may think their shares are undervalued and they can generate a larger return investing in itself versus investing in other areas
  • Lastly, buybacks mask the dilution caused by exercised options – this is the more controversial reason for buybacks – companies use options to attract talent, but these options dilute the outstanding shares which is a negative for investors

Buybacks Versus Dividends

I’m a firm believer that dividends are much better for investors than buybacks.  Having cash in my pocket is the only guarantee as an investor.  As shown above, management can frequently be wrong in their projected returns and they can frequently be acting in their own interest with regard to masking dilution from insider option activity.

With regard to financial ratios, these arguments seem to be more about short-term targets and stock manipulation.  For the long-term, having a high level of cash (especially in times of economic uncertainty) is not a bad strategy – for comparison, check out the levels of cash on the balance sheet of Apple, Inc. (AAPL).

For more reading on this argument, click here to read more about why dividends are much better than buybacks for investors.

Buybacks can be great sometimes, but they can also be not-so-great.  If management is really all about shareholder return, they will distribute cash in the form of dividends.  I will stand by this argument.

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