TSCI Street Pulse - January 19, 2010

Do Share Repurchases Send A Negative Signal To The Market?

Corporate share repurchases have come into vogue as a way to distribute cash to shareholders.  A “share repurchase” is when a company buys its own shares in the marketplace.  Share repurchases return money to the shareholder without the higher taxation that accompanies dividends.  Share repurchases also provide management with more financial discretion than with dividends.  Equity markets traditionally punish companies for lowering dividend payments; however, when companies lower share repurchase levels investors have not responded in the same punitive manner.    

On the other side of the argument, there are numerous questions around why companies execute share repurchases.  Why purchase now?  Where is the business case supporting the share repurchase?  What is the return on investment?  Is this the best use of corporate cash?  Most companies provide minimal transparency surrounding share repurchase announcements.  In most instances, the company only provides the number of shares repurchased, average price per share, and total cash outlay.  Management teams fail to provide a detailed justification for the repurchases.  

Numerous academic studies indicate the market reacts favorably to share repurchase announcements.  This is clearly not due to the quality or scale of information provided by management, but rather the implied rationale for the repurchases (I.E., shares are undervalued).  A closer analysis of share repurchases may show that an adverse reaction to share repurchases may be more appropriate.  

There are many reasons that companies repurchase shares that do not fully benefit shareholders.  Sometimes companies buy back stock so that it can issue additional shares for stock options.  The repurchase of shares prevents the dilution of equity to the existing shareholders, but it also results in a transfer of equity from the shareholders to management.  

Another reason for the repurchase of stock is to manipulate earnings per share (EPS).  Many companies issue earnings guidance on a per share basis.  By repurchasing its own shares, the company reduces the number of outstanding shares, thus artificially inflating its EPS.  Management is able to meet or exceed guidance through this means without actually achieving its stated goals, operationally.  This tactic misleads investors.  The buying back of shares can be a deliberate attempt to conceal management missteps or delay the release of adverse financial information.  

Similar to external guidance, many senior managers have bonuses tied to internal EPS objectives.  Senior managers have a significant self-interest in ensuring that the company meets the internal EPS level.  Share repurchases can manipulate per share results to the benefit of management and at the peril of the investor.  The achievement of the objective results in another transfer of equity from the shareholders to management.    

There is minimal evidence to suggest managers can consistently repurchase shares when share prices are undervalued.  To the contrary, most management teams repurchase shares when they have high free cash flow.  In general, higher cash flows, a good economy, and rising stock prices tend to all occur around the same time.  Companies buy their own stock at exactly the wrong time, when the stock is appreciating or has already appreciated.  Companies also tend to avoid share repurchases during recessions (e.g., 2001, 2002, and 2008) or lower cash flow periods, which also tend to be when stock prices are depressed.  

Shareholders receive modest benefits when companies repurchase shares, but most companies do not provide enough information to the average investor.  As the above examples demonstrate, many share repurchases benefit management at the expense of shareholders.  Until companies are more forthright about their rationale for share repurchases, investors should remain skeptical about why management is using shareholder cash to reduce shares.  

Research Available: Tiarta LLC

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John W. Taylor is the president and founder of Tiarta LLC (www.tiarta.com), an independent research firm that utilizes managerial statements and financial transparency to assess downside risk on publicly-held companies.  Prior to founding Tiarta, John worked in corporate finance, management consulting, and criminal investigations with the U.S. Secret Service.