To Buyback or Not Buyback, That is the Question?

To Buyback or Not Buyback, That is the Question?

As part of The CARES Act, Congress imposed restrictions on stock buybacks. There was bipartisan support for this idea. Billionaire Mark Cuban argued that the rule for any company that receives federal assistance is, “No buybacks. Not now. Not a year from now. Not 20 years from now. Not ever.” Senate Minority Leader Chuck Schumer declared on-air: “Our motto in this is ‘workers first.’ …. These buybacks, they infuriate me. We should not be allowing them to do buybacks, raise corporate salaries.” Sen. Elizabeth Warren said that any corporate recipient of government assistance should be “permanently prohibited from engaging in share repurchases.” President Trump joined the chorus arguing, “I am strongly recommending a buyback exclusion. You can’t take a billion dollars of the money and just buy back your stock and increase the value.” However, others have argued that this policy is The Worst Coronavirus Idea.”

 

How it Happened

The airline industry was the poster child for arguments against buybacks.  Airlines for America, which represents major U.S. passenger and cargo air carrier companies, requested government assistance because of (i) the coronavirus crisis, and (ii) several of the largest carriers had used the majority of their free cash flow on share buybacks over the last decade. Given that airlines have a propensity for going bankrupt with over 60 since 1991, and being unprepared for hard times including the Sept. 11, 2001, attacks and the volcanic eruption in Iceland in 2010 that disrupted air travel, building up cash for a rainy day hasn’t been part of their plan.

Airline Free Cash Flow ($MM) Share Buybacks ($MM) Buybacks/FCF
Southwest Airlines Co. 15,103 10,650 71%
Alaska Air Group, Inc. 4,948 1,590 32
Delta Air Lines, Inc. 23,186 11,430 49%
United Airlines Holdings, Inc. 11,526 8,883 77%
American Airlines Group, Inc. (7,935) 12,957 N/A
JetBlue Airways Corporation 2,347 1,771 75%

Source: FactSet

However, airlines weren’t the only ones spending free cash flow on share buybacks. As can be seen below, nearly 50% of the saving from the 2017 Tax Cut and Jobs Act went to share buybacks.

Arguments For Buybacks

Share buybacks are very popular. According to Federal Reserve data compiled by Goldman Sachs, over the past nine years, corporations have acquired more of their stocks – $3.8 trillion—than every other type of investor (individuals, mutual funds, pension funds, foreign investors) combined. So why do they do it?

  • An efficient way to return money to shareholders. By reducing the number of shares outstanding in the market, a buyback lifts the price of each remaining shares.

  • A Valuable source of cash. Donald L. Luskin and Chris Hynes made this argument in a Wall Street Opinion Editorial. It has to be the worst reason I have heard. If people need cash, they can sell their shares on the market; they don’t need the company to repurchase them.

  • More tax-efficient than dividends. If the shareholder has held the shares long enough to qualify for long term capital gains treatment, this is true. Dividends are taxed at 22% while the tax rate for capital gains is 0%,15%, or 20% depending on the taxpayers’ level of income.

  • Management captures the share bump. An analysis by the SEC revealed that executives, on average, sold five times as much stock in the eight days following a buyback announcement as they had on an ordinary day. According to SEC Commissioner Robert Jackson Jr., “Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement.”

  • Boost management’s compensation. Following the adoption of Milton Friedman’s idea of “creating shareholder value,” more and more companies granted CEOs large blocks of company stock and stock options to align management with the corporate goal. However, with large portfolios of their own company’s stock, the desire to manipulate the share price with share buybacks was a temptation few CEOs could resist. As a recent article noted, “Today, the abuse of stock buybacks is so widespread that naming abusers is a bit like singling out snowflakes for ruining the driveway.”

Arguments Against Buybacks

  • Deprives companies of liquidity. As a recent Harvard Business Review article noted, when companies undertake buybacks, they deprive themselves of the cash that might help them cope when sales and profits decline in an economic downturn.

  • The share price boost is short-lived. A study by the research firm Fortuna Advisors found that five years out, the stocks of companies that engaged in substantial buybacks performed worse for shareholders than the shares of companies that didn’t.

  • The propensity to buy when the price is high and not when it’s low. Companies tend to overpay for their shares, diluting return to shareholders. The is overwhelming evidence that substantial buyback companies usually create less value for shareholders over time.

  • Lack of investment in things that grow shareholder value. Those companies that reinvested a higher percentage of their cash generation into capital expenditures, research and development, cash acquisitions, and working capital delivered substantially higher total shareholder return than those that reinvested less.

  • Lack of Imagination by Management. If the best use of the company’s money is share buybacks, then unless the shares are undervalued (20%+), management has effectively given up on planning to grow the company in new markets or products, through acquisition or investment. Such a strategy is a reflection of failed management.

 

Conclusion

 

From the above, it is apparent that there are few good reasons for share buybacks other than to boost management’s earnings. Hopefully, the current environment will cause management to reflect and do their jobs more efficiently so that there is real shareholder growth. As the Atlantic article pointed out.

“Craig Menear, the chairman and CEO of Home Depot mentioned on a conference call with investors in February 2018, their “plan to repurchase approximately $4 billion of outstanding shares during the year.” The next day, he sold 113,687 shares, netting $18 million. The following day, he was granted 38,689 new shares and promptly sold 24,286 shares for a profit of $4.5 million. Though Menear’s stated compensation in SEC filings was $11.4 million for 2018, stock sales helped him earn an additional $30 million for the year. 

By contrast, the median worker pay at Home Depot is $23,000 a year. If the money spent on buybacks had been used to boost salaries, the Roosevelt Institute and the National Employment Law Project calculated, each worker would have made an additional $18,000 a year. But buybacks are more than just unfair. They’re myopic. Amazon (which hasn’t repurchased a share in seven years) is presently making the sort of investments in people, technology, and products that could eventually make Home Depot irrelevant. When that happens, Home Depot will probably wish it hadn’t spent all those billions on buying back 35 percent of its shares. “When you’ve got a mature company when everything seems to be going smoothly, that’s the exact moment you need to start worrying Jeff Bezos is going to start eating your lunch,” said the shareholder activist Nell Minow.”

 

Copyright (c) 2020, Marc A. Borrelli

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To the shock and horror of many in the business community, top CEOs from the Business Roundtable stated two weeks ago that Shareholder Value is not Everything. These CEOs, including the leaders of Apple and JPMorgan Chase, argued that companies must also invest in employees and deliver value to customers.

The Business Roundtable is trying to redefine the role of business in society — and how an increasingly skeptical public perceives companies. Breaking with decades of the Friedman Doctrine, which holds that a firm’s only responsibility is to its shareholders, the Business Roundtable stated that companies should no longer advance only the interests of shareholders. Instead, companies must also invest in their employees, protect the environment, and deal fairly and ethically with their suppliers.

This shift in corporate ideology comes at a moment of increasing tension in corporate America, as big companies face mounting discontent over income inequality, harmful products, and poor working conditions.

There have been many arguments for and against this stand, i.e., Why Maximizing Shareholder Value Is Finally Dying, Corporations Can Shun Shareholders, But Not Profits, Stakeholder Capitalism Will Fail If It’s Just Talk, and We must Rethink the Purpose of the Corporation.

Personally, however, I think that this is a move in the right direction for the following reasons.

The Friedman Doctrine is backward.

Shareholder value is the result of corporate purpose and Mission and cannot be the purpose and Mission. Simon Senik’s “Start with Why,” in my opinion, best describes how to develop a corporate mission. An example of what happens when a company game up is mission and followed the Friedman Doctrine was Imperial Chemical Industries, who changed its mission from “We aim to be the finest chemical company in the world“ to “We aim to Maximize Shareholder Value“ in the 1990s. Prior to the change, ICI was considered one of the finest companies in Britain, today it no longer exists having been slowly sold off many parts to repay its debt before finally being sold to AkzoNobel in 2008.

 

Few stakeholders within the organization.

If the maximization of shareholder value is the corporate Mission, then there are few within the organization, other than some high-level employees, who have a stake in the Mission. Working to increase the wealth of others is not something most employees get behind. It reminds me of the old joke:

Employee: “Nice new car, boss”

Boss: “Well, if you set yourself targets, work hard, stay focused, next year I’ll be able to buy an even better one.”

Employees are only attracted to the company with this mission by what they will get, i.e., money or career advancement, so there is little commitment to the organization. If the expected benefits aren’t delivered or someone else offers more money, the employees will move on, increasing employee turnover. As a result, with few employees embracing the Mission and no other purpose, nothing is of importance to quality, service, and profits fall, decreasing brand value and shareholder value. Employees who embrace the Mission and are satisfied will serve customers better, increasing brand value. Employee happiness and business success are linked.

 

Few stakeholders outside the organization.

If the employees see no value in the Mission, customers and suppliers don’t. If the Mission is only to make money, customers and suppliers understand the Mission as a goal of extracting more value from them. Thus, they move from commitment to the organization (i.e., putting an Apple sticker on your car) to engaging with the company because there is no better alternative. If the company gets into financial trouble, they are less likely to support it, but rather let it fail. Working with suppliers is a relationship with the power moves back and forth and both parties treat it with care knowing they will be on the receiving end at some point. However, if shareholder value maximization is the only goal of the organization, suppliers abandon that relationship knowing the company has in its behavior.

 

Lack of Investment in Interesting products.

The Friedman Doctrine has led to many companies killing off research centers, which generated great benefits unidentified at the start. Ten years ago, the majority of technology products were offshoots from two places, Xerox Parc and Bell Labs, both of which no longer exist because of the Friedman doctrine. Between share buybacks and dividends, corporate investment in new areas has fallen. Google, SpaceX, and a few other companies have stepped into this space, but it is far more limited, thus limiting the future growth potential for the US.

 

Lack of Training.

Thirty years ago, when I graduated from college, many companies had training programs which took in graduates and trained them over several years. These programs knew that most of the trainees would leave the organization and thus canceled under the Friedman Doctrine. However, I would argue that these programs had three positive results:

  1. Well Trained Employees. A common complaint today is that graduates don’t know anything; however, I would say we didn’t know more, but we benefited from such programs.
  2. Loyalty to the Organization. Employees who moved on had developed a commitment to the organization that had trained them. Over the years they referred work to it and would engage with that company because of the feeling towards it.
  3. The camaraderie with their fellow trainees. Employees who went through the training program built a camaraderie with their fellow cohorts, which lasted a lifetime. I have met many accountants who came through the training programs provided by Arthur Anderson and still talk about their classmates and the connections they made. This camaraderie further built referral networks that benefited those that stayed behind and the training organization.

 

Lack of Integrity.

I recently heard Kirk Lippold‘s definition of integrity, which is:

“Integrity defines leadership. Without uncompromising integrity, failure becomes the natural default to success. It’s not just doing the right thing at the right time for the right reasons, even if no one is looking. That’s ethics. Integrity is doing all those ethical things regardless of the consequences.”

If the Mission is to maximize shareholder value, then I believe the organization develops a modus operandi of maximizing profit as the proxy for shareholder value. Since profit is measured monthly and quarterly, the corporate focus becomes more short term and undertakes anything to cut costs and maximize revenue. Thus, companies lose their integrity, sacrificing what makes them special for money, and losing customer loyalty and brand value. Recent examples of this would be Wells Fargo fake accounts scandal, and the Boeing and the 737 Max. An example of long term brand damage is the Sun Newspaper and Liverpool boycott, and many others. For a an example at what lack integrity can do see The Whistleblower (trailer is below) which based on a true story. Thus to quote Timothy 6:10, “For the love of money is the root of all evil.”

An example of a Mission leading shareholder value is Johnson & Johnson’s response at the time of the Tylenol recall. J&J’s Mission is to “. . . solutions that create a better, healthier world.” Living that Mission, created goodwill and tremendous brand loyalty within the US. A company’s brand is its reputation, and damage done takes a very long time to recover, destroying shareholder value.

Therefore, I think that the Business Roundtable is correct; Shareholder Value cannot be the purpose of the organization. If the company focuses on its Mission and engages its employees, customers, and suppliers, increases in shareholder value should result. Shareholder value should be measured, and companies should see how they are doing, but it is one metric and should not be the purpose. Further, in my opinion, the Friedman doctrine has done untold damage to the US over the years. Private Equity Groups, which own over $2.5 trillion of companies globally, primary focus on Shareholder Value has had mixed, if not harmful, results for their investment companies.

 

© 2019 Marc Borrelli All Rights Reserved

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I am sure that many of these entrepreneurs would say that they did plan to sell, hired an investment banker, and went through a process. However, this is the end part of the process and planning needs to start 3+ years in advance to be truly effective. In the sub $100MM market, to maximize the value of a business is not hoping some banker knows a buyer that will pay substantially more, but rather properly preparing the company for sale.

The lack of planning I believe is due to two issues: (i) entrepreneurs don’t fully realize the benefits of planning, and (ii) they don’t look at their business with external objectivity.

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  • Allow your tax and wealth advisors to minimize your taxes and maximize wealth transfers;

  • Enable you to implement profit improvement measures and show the effect of those to a potential buyer;

  • Ensure that the company has a strategic plan that it is executing, and that the management team knows it, breathes it and lives it;

  • Ensure that your customer base is diverse, and you have developed recurring revenue lines, if possible;

  • Provide the opportunity to ensure that your contracts will allow for a sale and that they are relatively similar; and

  • Allow you to improve the company’s performance, to ensure it is performing in the top quartile of similar businesses.

All of these steps will increase the value to a buyer and increase the net proceeds to the seller. However, they take time to develop, implement and show results. They cannot be done overnight. This is like running a marathon, you can go out and run one, but if you train and work on it, you will do much better, but that takes time. Thus, the planning needs to start well in advance.

Finally, markets operate in cycles, which may not coincide with your plans. As inconvenient as this is, you have no control over market timing and must deal with the market conditions as they occur. Therefore, if the market window closes before the sale is complete, you can either sell at a lower price or wait 6 – 8 years for market conditions to return. To minimize this risk, always run your business as though you are going sell it “tomorrow.” Doing so will allow you to take advantage of market conditions when they occur and maximize your proceeds.

 

© 2015 Marc Borrelli All Rights Reserved

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