On Wednesday, Bristol-Myers Squibb (NYSE: BMY) said it would expand its stock buyback program by 40 million shares, adding $2 billion to the previous $12 billion buyback authorization. Yes, this stock repurchase authority allows for the purchase of 400 million shares -- roughly one-fifth of shares outstanding.
That's a good thing for shareholders of the company, right? The answer is maybe. Unless you know Bristol-Myers' financial situation and intrinsic value, you don't have enough information to decide.
Why would a company buy back stock?
It is possible to increase shareholder value through stock buybacks. A buyback essentially represents an investment -- like any other equity investment -- in a company's own stock. If the company's stock is trading far below its intrinsic value, then, theoretically, it should outperform the market in the future, and thus is an attractive investment opportunity for all investors, including the company itself.
In that sense, stock buybacks should be treated like any other use of capital. To me, managing a company is all about allocating capital. There are subdivisions of allocation -- investment in capital goods or new business lines, paying employees, paying dividends, etc. -- but management all comes down to how well it uses the capital at its disposal to create value for shareholders. That's a manager's job. If buying back stock creates value, she should do it.
The trouble with buybacks
The problem is that companies often use stock buybacks for other reasons. They may use them to mask the dilutive effect of stock option grants. They may use them to convey a sense of optimism about the future of their companies. They may use them to lower the sharecount so earnings per share subsequently rises, giving the appearance of growth even though net income may remain flat.
Berkshire Hathaway (NYSE: BRK.A) Chairman Warren "The Allocator" Buffett decried such uses of capital in his 1999 letter to the shareholders: "Repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price."
If it were a matter of buying good shares at a low price, you would think lots of companies would have been buying back shares in the first quarter of 2001. You would be wrong. As of May 15, 201 U.S. companies had announced share repurchases, a 44% decline from that time last year. That's because companies can't afford to use debt to prop up share prices when operations are imperiled. While it's understandable that companies become fiscally conservative now, the fact that they ever used debt to buy stock -- thus putting the company in a vulnerable financial position -- reflects badly on their management.
A bad buyback: Eastman Kodak
Take the case of Eastman Kodak (NYSE: EK). On March 2, it suspended the share repurchase program it initiated on April 16, 1999. During the buyback, Kodak bought 32 million shares at an average price of $56.25 per share. That's $1.8 billion invested between 1999 and 2001 -- during which time total debt, held at about a 7% rate, increased by $2.3 billion. Kodak was paying interest on debt to invest in its own shares, and it lost money on the shares it bought. Unless the stock rebounds quite heartily, that is poor capital allocation. Ironically, Kodak shares are up 11% since the repurchase program was suspended.
A good buyback: PP&L Resources
Don't get the impression all stock buybacks are bad. PP&L Resources (NYSE: PPL) initiated a stock buyback in August 1998. Shareowners had the opportunity to offer their shares for sale within a price range of $24.50 to $27 per share (the stock had closed at $24.50 the day before PP&L's offer). After offers were made, the company evaluated them and determined the lowest price within the range of offers that allowed it to purchase up to 17 million shares. PP&L then paid this price for all repurchased shares, even those offered at a lower price.
This buyback came at a difficult, uncertain time for the company, but it was a brilliant and exemplary move for a number of reasons. The power industry was undergoing a significant change following deregulation, and PP&L felt that it needed to increase its investments in the growth opportunities newly open to its business. Rather than pay out in dividends 80-90% of its annual earnings, PP&L decided to cut its dividend payout roughly in half, to 45-55%.
PP&L recognized that many of its shareholders owned the stock for its dividend and wanted to give them an opportunity to sell without driving the stock price down. "While we certainly don't want to lose shareowners," said Chairman and CEO William Hecht at the time, "many of whom have been very loyal to the company over the years, we understand that some of our investors are very dividend-oriented and may want to change their investment strategy with regard to PP&L Resources."
This is what a stock buyback ought to be: an even-handed consideration of all shareholders' needs and interests, presented with supporting information about the company's price range, and beneficial to all parties concerned. This also turned out to be an excellent use of capital, as the stock approximately doubled in the next three years. Part of the credit for that goes to the decision to rebalance dividends to allow for investment in the newly deregulated industry. Great capital allocation all around.
So is Bristol-Myers' buyback a good use of capital? Well, it's not being done with debt; the company's total debt is less than its cash on hand, and it has scads of free cash flow, even after paying dividends. That's a good start. The company has very high returns on capital, so a reinvestment in the business would be nice, but management must decide whether incremental investment would yield a similarly high return. If not, then a higher dividend -- also initiated Wednesday -- and/or a stock buyback may be wise. Though its shares aren't cheap, buying them back doesn't seem like a foolish move.
Are the companies you own buying back shares responsibly?
Brian Lund wouldn't buy back shares in himself at these levels. Maybe after he loses a few pounds. He doesn't own any of the stocks mentioned in this article.
