Companies are increasingly using cash for share buybacks rather than paying dividends
The shock of the credit crisis made repaying borrowings one of the big financial trends of the past two years. Now that companies feel more stable, they are beginning to notice the cheapness of debt compared with equity. And this has prompted a new trend, particularly evident among major US corporates, of raising cash to – among other things – boost earnings per share by conducting share buybacks.
In October, tech giant IBM said it had added $10 bn to share buyback plans and that it will use debt to finance these. The same month saw auction website eBay’s $1.5 bn debut bond deal to fund part of a $2.5 bn share buyback plan, and drinks group PepsiCo sold $2.25 bn of bonds for several purposes, including share buybacks. Those efforts followed similar activity in September in the technology space: Microsoft borrowed $4.5 bn for a share repurchase, and Hewlett Packard fired off a $3 bn issue for acquisitions and ‘general corporate purposes’ concurrent with a $10 bn buyback announcement.
There is evidence to suggest the trend toward buybacks is wider, too. Research group Birinyi Associates says that in the second quarter of this year executed buybacks increased by 50 percent in the US market, hitting $85 bn. While this is far below the $228 bn reached in the third quarter of 2007, it represents a return to levels last seen in mid-2005.
Many observers view this as a natural next step in the cycle and, in a note earlier this month, UBS analyst Karen Olney observed: ‘We think 2011 will be the year where the redeployment of cash piles and/or an increase in gearing gain momentum/critical mass. While markets have rallied from mid-summer and are near their April highs, at a 2011 P/E of 10.5x we are still fundamentally bullish on European equities and feel they can weather some modest earnings disappointment next year.’
The trans-Atlantic divide
The investment bank argues that while dividends are more often the preferred method of returning cash to shareholders – this has certainly been the case for a long time in the UK, although much less so in the US – on average buybacks have outperformed by 3.8 percent on a one-month basis and 5.1 percent on a three-month basis, going on recent history.
Meanwhile, ‘revenue visibility issues’ mean large-scale M&A is still viewed by corporates as a major undertaking – with 80 percent of deals this year coming in below $5 bn – while capital expenditure and working capital investment could spike from a four-year low, making discretionary spend on buybacks preferable to a dividend hike.
This means more of what we have seen in the US can be expected and, in Europe, fixed income analysts identify companies such as ABB, AstraZeneca, GSK, Nestlé and Unilever as all possible buyback candidates, as well as BAT, Smith & Nephew and TeliaSonera.
‘A legacy of the credit crunch is that companies have been shoring up their balance sheets,’ explains Jim Renwick, head of UK equity capital markets and corporate broking at Barclays Capital. ‘Many firms are nervous about M&A, while a number have cut investment such as R&D. The result of this has been a build-up of cash and liquidity on companies’ balance sheets. The attitude to buybacks in the UK is different from that in the US. The UK is more dividend-driven than buyback-driven: UK shareholders believe dividends are a sign of permanent and regular returns, whereas buybacks, although EPS-enhancing, are seen as one-off benefits.’
It’s certainly the case that a significant move toward buybacks would represent a change in culture for UK investors. But whether in the US or the UK, it’s not necessarily a question of one thing or the other. As recently as mid-November 2010, toy maker Mattel announced it would increase its existing buyback program by $500 mn; on the same day the board said it would be making changes to payments of dividends to shareholders. These would not only rise from 75 cents a share to 83 cents a share; the company would also switch from paying out on an annual basis to a quarterly basis, with effect from 2011. It was all part of the company’s commitment to ‘returning excess funds to stockholders,’ said Robert Eckert, Mattel’s chairman and chief executive.
In today’s market, a yield of 3.5 percent (Mattel’s effective dividend rate on the day the company made the announcement) is not to be sniffed at, and that’s true whichever side of the Atlantic you’re on. But in the US the buyback drivers remain clear: ‘There are two reasons why companies are doing this,’ says Bill Koefoed, general manager of IR at Microsoft, one of the major corporations using debt to cancel shares. ‘First, a very inexpensive interest rate environment; second, there is a significant amount of offshore cash for US multinationals: Cisco CEO John Chambers and Oracle president Safra Catz estimate more than $1 tn of profits are held offshore. Debt offers a way to generate onshore cash, without paying the repatriation taxes.’
Say it quietly
Koefoed insists investors are ‘generally happy’ with the approach of raising debt for buybacks. Others argue that, from an investor relations point of view, the process must be conducted less obviously.
‘Typically, a company will issue a bond deal for ‘general corporate purposes’ and almost simultaneously announce a buyback, rather than outright state that proceeds from a bond deal will be used for a buyback,’ notes Guy LeBas, chief fixed income strategist at broker Janney Montgomery Scott. ‘Leveraging up – which is essentially what a share buyback is – is inherently unfriendly to credit quality, so many issuers try to blunt the blow by making it appear as if a debt issue has more than just leveraging as its justification. It’s not a requirement that an issuer mix buyback and ‘other’ debt issuance, but it does make the appearance of the transaction a bit more palatable.’
Moreover, buybacks are not always seen as a positive move from an IR perspective. ‘In the UK, when a company announces a buyback, investors tend to feel the firm can’t think of anything better to do with its cash,’ says one investment banker, who did not want to be named. ‘It is seen in the UK as a dull thing to do and often the stock rallies but then drops after you’ve done the buyback.’
London-based bankers still confirm they are actively pushing buybacks, however, funded via debt or otherwise, to their major corporate clients. ‘We’re marketing buybacks pretty widely to help companies achieve outperformance,’ says one. Another phrases it thus: ‘Undervalued corporates can take advantage of directionless value sentiment and desire for enhanced yield by using a buyback to trim away the ‘non-believers’ at prices below fair value, to the benefit of ‘believers’ who remain as shareholders.’
Cynics might suggest this push is motivated by the healthy investment banking fees involved in a debt issue and share buyback proposal, compared with a company simply raising its dividend.
Still, apart from the potential performance of the shares, there are other IR advantages to the debt/buyback approach. ‘If you cut a dividend, your reputation takes a hit,’ notes Rob Leiphart, an analyst at Birinyi. ‘But if you promise a $5 bn buyback and you don’t do all of it, I can’t think of any examples of a company getting beaten up for that.’
So can any corporate try this? Probably not. ‘When fundamentals are generally buoyant, copycat competitors try to mimic the buyback Titans,’ UBS observed in a note on the subject published in summer 2010. ‘In the last cycle, a number of these could not follow through. So it is precisely in this environment, in the early stages of a buyback cycle when it is harder to be mimicked, that the confident, cash and cash flow-rich, undervalued firm with low business and financial risk can create value through a big buyback.’
