IBM's (IBM) earnings implosion last week created an uproar about the merits of share repurchases and financial engineering. What has garnered so much attention is the idea that buybacks only mask problems and are always a waste of shareholders' money. The corollary is that only if a company reinvests in its businesses or makes acquisitions can they grow value in the "right" way.
We strongly disagree with this blanket conclusion. We believe that buybacks can be a powerful tool to enhance earnings and shareholder value under the right circumstances. The down side is that buybacks can destroy value if used incorrectly.
Below are the critical conditions to drive value via share repurchases. If these conditions exist and the company has developed an aggressive share buyback policy, then it significantly enhances the stock's attractiveness. We have also identified the red flags. If these conditions are present, investors should be wary and look elsewhere at other buyback candidates.
Value-Enhancing Buybacks:
- Cash for a buyback is used only after the company adequately reinvests to maintain its business and in new projects to sustain and improve its market position that meet its return on investment hurdle.
- The company's balance sheet, earnings characteristics and bank covenants allow for the efficient payout of excess cash.
- Repurchases are executed in a consistent, disciplined manner over time and at modest price-to-earnings multiples. We prefer less than 12x earnings, but are okay at less than 15x earnings and below the market's multiple.
- Ultimately, the buyback must directly result in an equivalent reduction of shares outstanding.
Buybacks That Can Destroy Value:
- Buybacks funded by debt or by under-investing in the core businesses.
- Stock is repurchased at an above-market multiple, and above 18x earnings.
- Stock is purchased to offset dilution from employee stock options or stock issue (i.e., the company is using the buyback to mask, and essentially fund, significant employee stock grants).
Financial engineering is not inherently bad, but instead is a valuable tactic that must be considered by shareholder-focused managements and boards. We strongly believe that share buybacks can be an effective tool to help drive shareholder value, but their success depends strongly on the details of the buyback's rationale and execution. Investors can use the above rules to help determine the value of this financial strategy.
At the time of publication, Katz had no positions in the stocks mentioned.