Wednesday, June 20, 2007

Leveraged Buybacks

Photo Sharing and Video Hosting at Photobucket Photo Sharing and Video Hosting at Photobucket In the latest manifestations of what Forbes magazine recently (here) called "the biggest buyback binge in the history of the market," both Home Depot and Expedia announced that they would undertake massive amounts of debt to buyback significant portions of their outstanding shares.

The Home Depot plan (which it announced here) is particularly mind-boggling. According to the Wall Street Journal’s June 20, 2007 article entitled "Home Depot Boosts Buyback, Sets Unit Sale" (here, subscription required), Home Depot’s plan authorizes additional share buybacks of $22.5 billion, bringing the total authorized level of share repurchases to a staggering $40 billion. This is a company with a $74.9 billion market cap. Although an asset sale will fund $10.3 billion of the newly authorized share buyback, the remaining $12.2 billion will be financed with debt.

Expedia's plan (which it announced here) is that it will repurchase as many as 117 million of its Class A shares, which represents as much as 42% of its shares, and will spend up to $3.5 billion, as much as $2.5 billion of which will be financed with debt. Expedia’s current market cap is $8.8 billion.

These companies share prices responded positively to these announcements, and there are indeed arguable benefits to these types of transactions. As the Wall Street Journal note (here, subscription required) in discussing the Expedia leveraged buyback, "reducing the outstanding stock can help a company boost per-share earnings, as the profit is divided by fewer shares. Also, interest payments on [the] debt are tax-deductible."

But not all of the effects of a leveraged buyback are beneficent or benign. As the recent Forbes article (here) commented, buybacks "give a temporary, one-time artificial boost to earnings, they cause creaky cash-poor companies to load up on debt, leaving them vulnerable should the economy unexpectedly deteriorate and they pulverize credit ratings, causing borrowing costs to soar." The credit rating concern may already have affected Home Depot; according to the Journal, Standard & Poor’s rating service and Moody’s Investor Service "both placed Home Depot’s credit ratings under review for possible downgrades."

Detailed research suggests that the buybacks, at best, may provide "a short-term steroid shot." The Forbes article quotes research from Birinyi Associates, which looked at the stock performance of 375 S & P companies that bought back shares in the six years through December 2006. Over that period, the companies’ median return post-buyback was 56%, far less than the 72% at companies that did not repurchase, and the average return post-buyback was 102%, less that then 131% at companies that did not repurchase.

Nevertheless, S & P 500 companies repurchased $432 billion of their own stock in 2006, more than triple the 2003 amount. Why are companies doing this? One guess is executive pay. The Forbes article notes that "buybacks can goose executive pay, because executive compensation is often linked to earnings per share." Indeed, the Journal article discussing the Expedia share buyback plan, in trying to understand the plan, noted that "Expedia’s proxy statement gives one explanation: Executive Compensation is pegged to, among other goals, enhancing per-share earnings. And that looks to be one result of this particular buyback." It is also probably worth noting that using share repurchases to boost executive bonus comp based on an EPS trigger is one of the practices for which Home Depot’s departed CEO Robert Nardelli was criticized, as I previously noted here.

One particularly troublesome form of share buybacks involves an aggressive, debt-financed buyback program that coincides with active insider sales. A recent study by Audit Integrity (cited in the Forbes article) identified 13 companies with market caps over $100 million that had both high levels of stock buybacks and insider selling. But the insiders sales don’t necessarily have to be contemporaneous to be troublesome; as the Forbes article notes, "insiders may be way too tempted to do buybacks so they can sell their holdings more lucratively once the buyback pushes the stock price higher."

As I discussed in my prior post (here) about Share Buybacks and D & O Risk, none of this is lost on the plaintiffs’ lawyers. Indeed, the Forbes article cites the settlement of the Sprint class action lawsuit settlement "in which Sprint agreed that it would no longer allow insiders to sell Sprint shares while the company was buying them." Sprint may have agreed to this under duress, but this requirement in fact seems like a prudent policy calculated to avoid activity that otherwise presents some troubling visuals. It should not be overlooked that this activity has already attracted the plaintiffs' lawyers attention.

The share repurchase phenomenon may eventually abate as long term interests rates rise and the era of cheap credit comes to an end. We are definitely not there yet, as the Home Depot and Expedia buyback programs announced this week demonstrate. But when the music stops, there are could be some companies, saddled with buyback-motivated debt they are unable to service, refinance or restructure, that could pay a very steep price for their "buyback binge."

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