Share repurchases

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<ol><li> 1. CAN CASH FLOW CONTINUE TO SUPPORT SOARING SHARE REPURCHASES? January 30, 2015 Will Becker wbecker@behindthenumbers.com 1 Despite a broad trading slowdown, companies are continuing to repurchase their own shares at the briskest clip since the financial crisis and helping to fuel the stock market rally. According to research firm Birinyi Associates, 740 firms had authorized repurchase programs through August of last year, the most since 2008. Meanwhile, in terms of participation, FactSet showed that 374 companies (or 75% of the S&amp;P 500 index) repurchased shares in 3Q14, spending $143.4 billion for the quarter, marking a year-over-year increase of 16%. On a trailing 12-month basis through 9/30/14, companies spent $567.2 billion on share repurchases, a year-over-year increase of 27%. What is interesting is that this growth in buybacks comes as overall stock-market volume has fallen, helping magnify the impact of repurchases. According to WSJ (9/15/14), in mid- August, about 25% of non-electronic trades executed at Goldman Sachs Group, excluding the high-frequency trading (HFT) that has come to dominate the market, involved companies buying back shares. That is more than twice the long-run trend, according to a person familiar with the matter. Meanwhile, companies with the largest buyback programs by dollar value have outperformed the broader market by 20% since 2008, according to an analysis by Barclays PLC. Jonathan Glionna, head of US equity strategy at Barclays, said, "There are a couple of reasons why companies do buybacks. One is that it seems to work; it makes stocks go up." However, this explained direct causality is hardly scientific and we would argue that even recent history shows this is a very flawed way of thinking. On a basic level, a company creates value when it is buying back shares below their intrinsic value. Conversely, it destroys value when it buys back shares above their intrinsic value. Unfortunately, management rarely views share repurchases under these terms, instead looking at them almost as a default option when companies have strong cash flow but cant find suitable capital investments. Of course, companies typically have more difficulty finding good investments when asset prices are high and returns on investment are low. With a dearth of internal projects meeting the cost of capital, too many companies turn to buybacks. Yet, it's precisely these periods when one can almost be assured that stock prices are over-inflated, as well. In essence, companies are merely exchanging one form of malinvestment (capital expenditures) for another (repurchases). Thus, managements seem to follow the herd-mentality when it comes to buybacks as the activity is largely ignored when interest in the stock market is low and stock prices are at or near their companies intrinsic values. Cash is held dearly by management and inactivity reigns despite attractive asset prices. Meanwhile, share repurchases peak at the height of bull markets when intrinsic values are sky-high. Cash is considered trash and management feels it has to do something with it. We note that repurchases recently bottomed at the heart of the financial crisis when stocks were their cheapest, and are now accelerating six years later after the S&amp;P 500 has more than tripled. Does this seem to be a smart allocation of cash or are we seeing another massive round of malinvestment? When companies repurchase their own shares, they decrease the number of outstanding stock available, which theoretically increases the stock value. Many investors consider this to be the most tax efficient method of returning cash to shareholders, since there is no tax on repurchasing shares. Remember, the highest tax on qualified dividend income is 15% for the top income tax bracket. When companies earn money, they pay taxes on it. When companies pay dividends, dividends are taxed again at the individual level. However, these investors seem to forget that the holders of stock who sold to the company end up paying a capital gains tax on their profit. While not all shareholders sell their shares to companies that are repurchasing their own stock, the ones that do could end up with a higher tax bill at the end of the day, especially if they were longer-term buy-and-hold investors. The current long- term capital gains rate is 20% for high-income investors. On top of that, households making more than $200,000 may also be subject to a 3.8% Medicare surtax on some of their investment income. That makes for a current top rate of 23.8%. Meanwhile, in his 1/20/15 State of the Union speech, President Obama called for raising the cap gains tax rate on households making over $500,000 to 28%. Additionally, shareholders must realize that when a company spends large amounts of money on share repurchases when it could be paying higher dividends instead, the companys management is limiting the shareholders control and increasing theirs. Shareholders are essentially relying on managements ability to judge whether its an appropriate time to repurchase shares, whereas when shareholders are paid a dividend they have complete control over that choice. Thus, we prefer the flexibility of dividends for shareholders since it allows them to direct their flow of income to where they think the best investment opportunities are at any given time. Share repurchases simply lack that flexibility. Next, in theory, share repurchases should equate to lower share counts, which should then inflate earnings per share (EPS). However, we see a large number of companies that </li><li> 2. Can Cash Flow Continue To Support Soaring Share Repurchases? Behind The Numbers Will Becker January 30, 2015 2 use share repurchases as a clever way to offset shareholder dilution from exercised stock options from management. We are always wary of companies that make large share repurchases yet fail to reduce their share count due to new issuance of stock to redeem employee stock options. In fact, despite the elevated levels of repurchases, one could argue that lower share count has barely helped EPS growth lately. According to research by Standard &amp; Poors, Compustat, and JP Morgan Asset Management, EPS for the S&amp;P 500 companies advanced by 22% year-over-year for 4Q13, yet lower share count only accounted for 0.1% of this increase: To make matters even worse, since buybacks are typically initiated in good times when stock prices are high, these corporations end up purchasing their own stock at inflated prices, only to have many of these same shares then redeemed by management as compensation committees increasingly hand out these perks in good times. So what happens to heavy share-repurchasing companies when the bad times hit? General Electric (GE) showed in 2008 how quickly repurchases can go wrong. According to The Dividend Growth Investor (6/23/09), In 2007, the company spent $12.319 billion buying back stock, which reduced the share count from 10,394 million to 10,218 million, or a decrease of 176 million shares. This comes out to $70/share, whereas the high and low prices of GE stock in 2007 were $42.15 and $34.50, respectively. This sure tells us that the company gave out at least one hundred million shares through option exercises. Facing a liquidity crunch in 2008, the company was forced to sell $12 billion worth of stock at $22.25/share, much lower than the price it had paid for buybacks over the past 4 years. Back in February 2009, the company cut its dividend as well in order to conserve cash. Thus, GE insiders got filthy rich in 2007-08, while the same GE shareholders that held the stock through the financial crisis quickly found themselves holding diluted shares of a company that held more debt, a cut dividend and a heavily depressed share price. Lastly, we are perhaps most concerned with companies that are willing to take on large amounts of debt to repurchase shares. With the 10-year Treasury yield heading back down to approximately 1.8% off its 3% range back in late 2013, more companies are now able to justify bond-backed share repurchases these days. Even companies with low dividend yields may find bond-backed repos hard to turn down. Meanwhile, there are likely few bankers that will discourage an S&amp;P 500 company - a super safe credit - to take on more debt in the interest of appeasing their shareholders through repurchases, perhaps even when interest rates are heading up. In Reuters (9/6/13), Jim Turner, head of debt capital markets at BNP Paribas, said, "When rates go up, any kind of debt financing becomes less attractive, but on a historical basis rates are still very low. If a company has debt capacity at its current ratings, and it makes sense from a capital optimization point of view, share repurchases with bond proceeds still make good sense." However, once again, we point to the GE example above as a prime example of what can go wrong when shareholders rely on repurchases to drive higher stock prices. Meanwhile, high debt can only potentially compound the problem, as it gives the company less financial flexibility in an economic downturn to make necessary capital expenditures, maintain a dividend, or cover other cash commitments to help the company recover. In short, when it comes to repurchases, we believe financial discipline must be strictly maintained. Not surprisingly, with the U.S. stock market probing record levels, share buybacks are expected to continue at a brisk pace in 2015. According to CNBC (11/11/14), an analysis by Goldman Sachs expects repurchases to increase by 18% to $707 billion in 2015. Goldman strategist David Kosten wrote, "Since the start of (the fourth quarter), a sector-neutral basket of 50 stocks with the highest buyback yields has outpaced the S&amp;P 500. From a strategic perspective, buybacks have been the largest source of overall U.S. equity demand in recent years." Yet, what is interesting is that Goldman projects only modest growth in capital expenditures for S&amp;P 500 companies in 2015. Though the current annualized pace for CapExat about $2.1 trillion, according to the latest Bureau of Economic Analysis figuresoutpaces the aggregate total for buybacks, the buyback pace is well ahead. After increasing by 9.7% year- over-year in 2Q14, the pace of the CapEx increase slowed to 5.5% in 3Q14. Goldman expects declining oil prices will sap CapEx activity at energy firms, resulting in just a 6% gain for 2015 even as nonfinancial companies sit on nearly $1.9 trillion in cash. However, for this exercise, we are going to challenge Goldmans expectation that the S&amp;P 500 can boost share repurchases by 18% in 2015. Frankly, we believe free cash flow for many of these companies could soon encounter a number of headwinds, thereby making it more difficult for them to expand their buyback programs. For some, the biggest hurdle that may pressure cash flow is restructurings. While most on Wall Street view restructurings as one-time events that largely deal with realigning businesses, reducing asset values and thereby lowering future depreciation, many of these charges were taken years ago and are still consuming cash. When companies shut down a business and layoff a number of employees, they are then required to make severance payments, cover healthcare and life insurance costs, and contribute to pension plans. As we addressed in our 10/31/14 Pensions Must Account For Longevity Risk report, the Society of Actuaries (SOA) updated their mortality estimates for the first time in 14 years, showing life expectancies for 65-year-old Americans is up more than two years. This rising longevity risk will be recognized in the form of higher pension contributions for many companies. Additionally, companies must pay to break leases or cancel outstanding purchase orders or </li><li> 3. Can Cash Flow Continue To Support Soaring Share Repurchases? Behind The Numbers Will Becker January 30, 2015 3 distribution agreements as part of these restructurings. Thus, these are big cash costs that can squeeze cash flow for a number of restructuring companies and force some of them to cut back on their share repurchases and/or other cash commitments. We screened the S&amp;P 500 index, excluding Financials, and looked for companies that have recently made large share repurchases and taken a string of sizeable restructuring charges. In particular, we focused on those charges in which a significant amount of it was taken in cash, thereby pressuring operating cash flow. For example, while a companys first restructuring may have been a $200 million charge with only about $55 million of that in cash, they may now be taking $500 million charges and $300 million is cash. Additionally, we screened for companies that have already drawn down their working capital so that source of cash is now gone. Finally, we looked at capital expenditures to see which companies have already slashed this spending to free cash and will likely have to ramp it back up to grow business and maintain existing capital. These are the companies that would seem to be in the most jeopardy of having to reduce their share repurchase activity going forward. We focused on the following four companies: Cisco Systems CSCO CSCO has recently undertaken two large restructuring plans the Fiscal 2011 Plan and the Fiscal 2014 Plan to realign businesses, consolidate excess facilities and sell manufacturing operations. Cash payments for restructurings have been heading much higher. Still, CSCOs operations have not improved with declining margins and negative sales growth leading to lower earnings. To boost cash, CSCO recently benefited from working capital improvements and CapEx remains fairly flat. However, the company recently initiated its first dividend program, which continues to ramp up. Share repurchases nearly doubled over the last twelve months ended 10/25/14, leading to a large adjusted free cash flow deficit for the period. CSCO continues to pay its executives heavily in stock, thereby minimizing share count reduction. Although CSCOs balance sheet remains fairly solid, debt jumped noticeably over the last year. General Mills GIS GIS has been a regular restructurer and has two big plans Project Catalyst and Project Century currently in progress. Yet, margins have been steadily falling for years, while sales fell year-over-year for last twelve months ended 11/23/14. Excluding working capital adjustments, operating cash flow declined over the last twelve months ended 11/23/14. Meanwhile, with CapEx heading higher, dividend coverage tightened noticeably over this period. With share repurchases jumping, GIS has now reported an adjusted free cash flow deficit over each of the last two twelve-month periods ended November. GIS continues to dole out stock for compensation and appears willing to take on debt to boost its share repurchase program. The companys net debt-to-EBITDA ratio was at 3.16 at 11/23/14. Coca-Cola KO KO has recently been involved in a number o...</li></ol>

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