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Sep 30, 1998

Bouncing baby buy-backs

Buy-backs are the height of fashion

One happy day in August, Jim Lillie found himself in the maternity ward holding not only his wife’s hand – and subsequently the tiny fingers of a new baby daughter – but the hands of analysts and investors as well. For that day World Color Press gave birth to a stock buy-back, and as the company’s new IRO, Lillie was obliged to walk the financial community through the details, albeit via cell phone.

Indeed, these days it seems a buy-back is born every minute somewhere in the world. In the US alone, buy-back announcements have averaged 100 a month for the last two years, with $1 trillion worth of them announced in the last decade. And the trend is spreading rapidly across the globe. More than ever, it’s crucial that IROs carefully explain the strategy behind them.

Buy-backs have traditionally been seen as management’s vote of confidence in an undervalued stock. They’re announcing to the world that the best use of cash they can find – better than external acquisition, paying down debt or increasing dividend pay-out – is an investment in their own company. The anticipated result is usually a boost in stock price – a not unrealistic hope given that buying back shares and retiring them reduces the number of shares outstanding, automatically boosting EPS.

Everyday business

Not all buy-backs are born equal, however. In World Color’s case, Lillie says it was just everyday business: the shares will be purchased on the open market to satisfy share delivery commitments under employee benefit plans, thus not actually reducing the float or affecting EPS. ‘We wanted to put the word out that there’s nothing occurring behind the scenes,’ he notes. ‘This is just an ordinary transaction, and the future looks great.’ As for the curious analysts and investors dialing up the maternity ward: ‘They were just circling around to make sure it was a non-event.’

Other companies indeed make World Color’s buy-back look like a baby in comparison. Take Merck & Co’s grandiose bow to shareholder value in the form of a new $5 bn repurchase plan, which supplements another $5 bn program in motion since February that has already seen $2.5 bn returned to shareholders. Or McDonald’s, which recently completed a three-year, $2 bn repurchase program and announced it would extend the buy-back as soon as plans are finalized.

Often a buy-back is launched following a drop in share price – both as a defensive maneuver to buoy the stock and an opportunistic way to scoop up bargain shares. Mobil Corp’s recent $500 mn repurchase announcement is an example, along with dozens of other cases this summer.

Elsewhere the situation is even more dire for stocks, but encouraging for buy-backs. In Poland, for example, shareholders in Mosostal Export were voting on a buy-back plan in mid-September after watching the stock drop on Russian rouble trouble. ‘The strategy behind our buy-back is clear,’ says Jan Dziembaj, public relations officer. ‘Our company is currently undervalued. And if you look at the Polish market right now, practically all of the 120 companies on the Warsaw exchange are going down. The situation is very difficult to predict. We want to take care of our shareholders by giving them the chance to sell.’

While the Asian contagion is exported around the world, the buy-back boom is being imported to the region. Hong Kong companies, for example, are resorting to buy-backs to bolster their stock prices, with eleven undertaking plans on a single day in August. China Telecom responded to a 42.8 percent drop in value over five months with a massive stock recall, reducing the percentage of shares in public hands from 23.5 to 18.5 percent. Japan has also seen buy-backs gain popularity since the government ushered in a more favorable tax regime in 1995. In a recent survey, Standard & Poor’s Fund Research in London found a positive long-term outlook on Japan with fund managers enthusiastic about a ‘better attitude’ toward share buy-backs and stock options.

Up and rolling

Buy-backs are sometimes used to change a company’s capital base. With plans to repurchase $440 mn worth of company stock, IRO Michael Steen-Knudsen of Denmark’s Novo Nordisk explains that it’s the first step in a strategy of ‘value-based management’ that will reduce the ratio of equity to debt. Currently Novo Nordisk’s capital base is 70 percent equity, and it aims to reduce that to 60 percent.

Novo Nordisk is one of the many European companies catching on to buy-backs. ‘There are eight to ten big Danish companies doing it right now, while a year ago there were only one or two,’ explains Steen-Knudsen. ‘Up until now it hasn’t been the habit or the culture to do it in Scandinavian countries. Also there are some tax complications, but now most of those have been solved.’

In Germany, many companies are anxiously waiting for tax law clarification on buy-backs. BASF, for example, recently announced a plan to buy back up to ten percent of its shares within 18 months. The purpose: to increase return on equity and boost EPS. The hurdle: it’s uncertain whether German buy-backs would be taxed like dividends or treated as a reduction in capital without tax implication. BASF is pushing hard for the latter route.

Even with the tax picture muddy, BASF experienced the usual result of a buy-back announcement: its stock price rose 5.5 percent. Novo Nordisk also got a 6.1 percent boost as it announced its half-year results. ‘And we’re convinced one of the reasons was the announcement of the repurchase program,’ says Steen-Knudsen. World Color, too, noticed a ‘pop’ when it revealed its buy-back aspirations.

Not all rosy

While most investors persist in lauding buy-backs, others are realizing not all of the plans are rosy. ‘There is increasing suspicion greeting buy-backs,’ cautions Richard Wines of Georgeson & Co. ‘Many people still view them as unalloyed good, but you have to be much more careful than that.’

Wines explains that a dutiful introspection over a company’s cost of funds and other opportunities is needed. If its price-to-earnings ratio is less than 20-25, a buy-back is going to end up increasing earnings per share. But if the valuation is any higher, then the buy-back may in fact reduce EPS because the company is paying too much for its own stock. One theory holds that simply reducing the number of shares outstanding produces a scarcity effect that drives up price, but Wines dismisses this supply-and-demand notion.

More doubt is bubbling up as institutional investors acknowledge that many buy-backs don’t reduce the number of shares outstanding because at the same time they’re issuing them to employees and management in the form of options. It’s one thing if World Color does this openly, while at the same time noting that ‘every senior manager continues to purchase the company’s stock on a regular basis.’ But quite another if it’s a sneaky short-cut to making management rich through options.

‘There is some concern about buy-backs used for stock option plans,’ notes Jamie Heard, CEO of the Proxy Monitor, a New York proxy advisory service. ‘They’re increasingly seen as just a backdoor way of transferring a lot of shareholder value without having to ask shareholders for their approval. A company could be faced with wanting to implement a broad-based stock option plan that would be heavily dilutive, and rather than asking shareholders to approve additional stock, cash is used to repurchase stock then effectively sell it to employees at a discount.’

Heard says he began to see some institutions focusing on this problem during the 1998 proxy season. Some companies with rich option plans engaging in buy-backs were being asked, Why are you doing this? ‘The use of buy-backs as a way to replenish shares for option plans is going to be receiving a lot more scrutiny than it has in the past,’ says Heard.

Skepticism warranted

Another shadow has been cast on buy-backs with an academic study showing that buy-back promises are often broken: 38 percent of the companies that announced repurchase plans during 1985-1991 failed to follow through; and in 66 percent of cases the companies bought fewer than half of the shares announced. Ironically, the report was published during a week in August that saw 36 companies announce buy-backs worth $11.6 bn – a record in 1998.

‘The findings warrant skepticism about whether a buy-back is intended to be a substantive policy, rather than just symbolic,’ says co-author James Westphal, assistant professor in the management department at the University of Texas. Indeed, Westphal began studying buy-backs on the hunch he would find evidence of ‘decoupling’: management initiates policies for symbolic reasons, then once those goals are met, there’s less incentive to actually implement the policies.

‘Ultimately, buy-backs can be traced to pressure from institutional investors to demonstrate commitment to shareholder returns,’ Westphal recounts. Now that he has discovered evidence that some of their promises turn out to be hollow, Westphal is interested in exploring the resulting effect on the market. ‘There’s already some awareness that buy-backs aren’t always implemented, but the market is still reacting in the way it has reacted in the past – by boosting stock price. Inertia has set in.’

So Westphal’s next project is studying the changing stock market response to buy-backs to see if there’s a ‘market learning effect’. Concluding on an optimistic note, he points out that some experts believe market response will get more and more positive, regardless of whether companies actually follow through on buy-back plans.