Corporate Stock Buyback Programs
An Effective (though potentially misleading) Practice

By: Christopher Zook
CAZ Investments

       Alcoa is once again on the clock. What were their 'whisper numbers" this quarter? Did you hear ABC, Inc. missed by a penny? Were there any non-recurring charges that impacted profits? How was management's forecast for the full-fiscal year? Comments like those can only mean one thing...it must be earnings season again.
       Yes, four times a year in January, April, July and October, most corporations announce their quarterly results and offer some insight into past performance and future expectations. Once upon a time, these detailed facts, figures, and management insights were reviewed only by those experienced analysts who tracked the individual companies; the data served to confirm how well (or not) they had predicted the quarterly results. While the average investor may have been aware of earnings season, they rarely dissected every last report or made buy/sell decisions based on one quarter's numbers.

That Was Then;
This Is Now

       In the new world of financial information overload, the average investor is now privy to the same data being analyzed (and overanalyzed) through the daily business press, financial cable channels, and related web sites and blogs.
       With so many investors now following the daily announcements, markets potentially move more rapidly and volatility often increases during these quarterly reporting periods.
       For 14 straight quarters, from Q3 2003 through Q4 2006, investors were busy slapping high fives as S&P 500 companies experienced double-digit earnings growth.
       Since that time, the numbers have slid a bit, though the anticipation and excitement returns each season. While some may argue that 'more is better" and access to this financial information is a very positive way to keep the investor informed, certain issues arise when that data is misinterpreted.
       History has seen many examples of corporate management engaging in accounting 'irregularities" to boast their numbers to this wider audience. Situations have included improper revenue recognition or off-balance sheet transactions (think Enron) or the inappropriate handling of company stock options.
       The regulatory environment has changed over the past few years to hopefully limit such situations, yet, earnings numbers still can be confusing and open to incorrect interpretations.
       While new regulations were created to hold management and directors responsible for any misstatements, other factors may be involved that lead to some potentially misleading results. For example, in recent times, numerous corporations have initiated large stock buyback programs and, while often deemed positive for shareholders, such plans can leave earnings reports open to some misinterpretations.

The Lowdown
on Share Buybacks

       Management often shows confidence in the future operations of their companies by buying back outstanding shares of their stocks. In some cases, they choose to use excess cash flow to repurchase these shares, revealing that they do not have other investment options that look quite as favorable. At other times, they borrow money and assume new debt to repurchase outstanding shares. In these situations, management has determined that the stock will deliver a higher rate of return than the company's cost of capital (borrowing costs).
       In the first quarter of 2007, Standards and Poor's estimated that companies bought back $118 billion worth of stock, an increase of over 17% from the same period in 2006. Over 100 companies reduced their outstanding shares by 4% or more during that quarter with technology and consumer goods companies among the top industries engaging in this practice. Investors generally react positively to such announcements and are often rewarded with higher share prices.
       There can be no question that stock buybacks are a positive for shareholders. That said, they often lead to some misleading analysis of the underlying companies' earnings growth that quarter.
       Since many analysts and investors look at earnings per share (EPS) statistics in evaluating profitability, those numbers may be elevated because fewer shares will be outstanding following the buybacks. Those companies that reduced shares by 4% in the first quarter reported stronger earnings growth (by approximately 4%) than were earned as the results of operations.
       Therefore, investors who glanced at the results to learn only the actual growth number (without analyzing the whole picture), may believe that the quarter was more successful than it really was.
       And since Wall Street assigns a multiple to trailing earnings in determining the appropriate price at which the stock should be trading, investors may be using results that are unsustainable for future quarters. After all, the whole point of paying a multiple to earnings is that investors believe that future growth is sustainable. How long will they pay for this balance sheet driven earnings growth, once they realize that the repurchases cannot last indefinitely?

Excess Cash Flow

       So why the sudden popularity in share buybacks? Management has three primary options to consider when spending a company's excess cash flow. It can buy back shares; it can reward shareholders with a one-time (or multiple period) dividend; it can allocate those funds into other potential operational growth opportunities. Historically, corporate execs have been very poor allocators of funds as acquisitions and investments in infrastructure and capital improvement projects (or people) have not always generated the cash flow anticipated.
       Dividends represent an effective alternative, though, in the past, the tax consequences were not as favorable to the shareholders who were taxed at ordinary income rates. While the tax laws have changed for the benefit of the investors, management often shies away from increasing dividends as the market views such transactions as one-time events and the underlying share prices are less prone to appreciate in the aftermath.
       Buybacks, on the other hand, are not perceived as one-time events and, therefore, management is able to reap some personal benefits from these programs. Bear in mind, many execs are compensated based on earnings growth and stock price appreciation and, therefore, may have incentives to engage in such repurchase programs. As earnings results look better with fewer shares outstanding, they may be rewarded with higher bonuses.
       As stock prices rise after the strong (perceived) earnings numbers, they see the value of their stock options and personal share holdings increase as well.

A Potential
(scary) Scenario

       As an extreme example, assume a company announces a massive self-tender and will be retiring as much as 15% of its common stock over the next few years. If the market doesn't look at buybacks in the same one-time manner as it does dividends, the share price trades up based on a multiple of the company's higher EPS. That earnings growth number will be elevated by about 15% over the periods that the buyback take place.
So what happens when excess liquidity has been depleted and the company has completed this repurchase program? How will its earnings look several quarters into the future, once analysts and investors have become accustomed to the financial ratios that reflect fewer shares outstanding during the past quarter?
       Logic states that unless the company produces a stellar operational period at that time, earnings growth rate will decline and the valuation and stock price could fall. Couple that scenario with a weakening economy. Bulls assume that everything will be rosy for the foreseeable future. Global growth from China, India etc. is compensating for the negative effects of a sluggish housing sector. Inflation numbers remain manageable at the moment, but what happens should oil prices continue to skyrocket and the subprime debacle creeps into other sectors of the economy, namely consumer-driven industries?
       Remember, the consumer accounts for 2/3 of the activity in the economy. Recently, Countrywide Financial Corp's CEO, Angelo Mozilo, proclaimed, 'We are experiencing home-price depreciation almost like never before, with the exception of the Great Depression." And delinquencies and defaults on subprime (and even prime) mortgages are expected to get worse before they get better.
       For years, homeowners have used their houses as a piggy bank, finding ways to take out money by reducing their equity to sustain their lifestyles and spending patterns. When cash-strapped borrowers cannot sell their homes or refinance their home mortgages, those piggy banks get turned off and a snowball effect causes the overall economy to slow. No more plasma TVs; no more updated home furnishings; fewer evenings out on the town; less elaborate vacations; less frequent purchases of new cars. While the luxury buyer may not be dramatically affected, middle America certainly could be.
       A sluggish economy will have a major impact on the credit markets and the way investors evaluate risk. Operating earnings begin to decline as a result of the weaker economy just in time for buyback programs to slow. Under these scenarios, investors are greeted with a quarter or more of lower than anticipated earnings growth and stock prices could decline accordingly.
       While no one is predicting the slowdown to happen today, tomorrow, next week or next month, at some point, a definitive event will transpire that prompts some weakness in the economy. (Maybe it already has.) Likewise, companies like Home Depot, Cisco, IBM, Oracle and many others have been engaged in significant repurchase programs that will surely slow at some point as well. And when these two phenomena coincide, the markets could experience some 'challenges."

Cash (flow) Is King

       While most equity market investors focus on earnings (and eagerly await the next earnings season), cash flow growth is actually a far more appropriate measurement of future profitability.
       And buybacks have no impact on operational cash flow growth. Think about this reasoning from a business owners' perspective. When people consider buying into a private business, they realize they are acquiring a future stream of cash flow and do not invest based on a reduction of share count. In other words, how much cash is being generated from operations today, and what are the projections for tomorrow? How long will it take to recoup the initial investment?
       Prospective buyers assign a multiple they are willing to pay for that cash flow based on its stability and the nature of the industry in which it operates. While earnings may be nice, cash flow is often the most important consideration.
       Why should investing in public stocks be any different than buying a private business? Unfortunately, even analysts often seem to overlook the crucial cash flow measures. One analyst pointed out that his firm projects EPS from a top down perspective and doesn't even consider how cash flow or buybacks impact earnings. Unfortunately there are still many investors who are less concerned with long-term investing and instead seek out that instant gratification of picking the hot stock-of-the-day.

What's an
Investor to Do?

       What good is a detailed analysis of a potential problem without suggesting a few solutions? The current buyback phenomenon should be considered a positive development for shareholders as it reveals management confidence in the underlying company. Such announcements typically result in stock appreciation, and earnings growth increases in the quarters of the repurchases.
       However, with all the positives, investors should be fully aware of the whole financial picture.

• Continue to monitor earnings growth, but only as one financial measurement;
• Be aware that buybacks serve to inflate those earnings growth numbers in the short-term and the long-term sustainability should be questioned;
• Think like a true business owner and focus more on cash flow growth as the most appropriate measurement of the future viability and profitability of the underlying company;
• Company boards should consider revising compensation packages to execs to focus more on total shareholder return and other more pertinent financial numbers and less on price appreciation and earnings growth (easier said than done).

       The market has become very complacent when it comes to earnings growth and that remains a very dangerous situation. These days, many investors merely lease their holdings for a short time (days, weeks, months) and then seek out that next stock-du-jour.
       Instead, they should be looking at their portfolios from an ownership position and focusing on the long-term. With that said, cash flow growth is a far more meaningful, long-term measurement.
        Editor's Note: Christopher Alan Zook is Chairman and Chief Investment Officer of CAZ Investments in Houston, Texas, which manages both traditional and alternative investments and fixed income products. Additionally, Zook is Chairman of the Board for the Texas Hedge Fund Association. For more information about CAZ Investments, visit www.cazinvestments.com.