Buybacks by US companies have been in the news for all the wrong reasons lately.
The aggressive share repurchase spree over the recent years has led to criticism that US companies are unable, or unwilling, to invest funds for future growth in their own businesses. Worse, many of these companies, which have stashed billions abroad in their efforts to avoid US taxes, are borrowing to implement their repurchases, notwithstanding that their cash flows may be unequal to the task of servicing this debt.
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Benefits of buyback programs on a manager’s compensation program
Increasingly there are murmurs of managers embarking on buyback programs with one eye on the beneficial impact of the repurchases on their own compensation programs. As executive appointment terms get shorter, corporate governance gets the back seat because managers find it easier to boost earnings per share by draining the company treasury than by business development – they are well aware that they are unlikely to be around when the chickens of under-investment come home to roost.
Not surprisingly, there is a decided decline in the trend of insider buying, indicating that managers are implementing corporate buybacks even though they themselves are really not so gung-ho about their company’s fortunes.
However, the latest Buyback Quarterly from Factset says Q2 of 2014 was notable for the fall in buybacks by companies. Could the tide be turning?
The largest companies held off repurchases in Q2
“Dollar-value share repurchases amounted to $123.7 billion over the second quarter and $539.3 billion for the trailing twelve months,” says Factset research analyst Michael Amenta in the Buyback Quarterly of September 17. “Quarterly buybacks declined year-over-year (-1.1%) for the first time since Q3 2012; and, due to record post-recession activity last quarter, Q2 showed the most severe quarter-over-quarter decline (-22.9%) since Q4 2011.”
One big reason for the fall: the top 10 companies that led the buyback charge apparently turned off the spigot – resulting in a $20 billion fall in Q2 on a sequential basis. Of this decline Apple Inc. (NASDAQ:AAPL) itself accounted $13.6 billion, while International Business Machines Corp. (NYSE:IBM) reduced buybacks by $5 billion.
“Largely as a result of the decline in repurchase activity from these two companies and Oracle Corporation (NYSE:ORCL) (-$860 million), the Information Technology sector showed the largest year-over-year decline (-19.3%) of sectors averaging more than $2 billion in quarterly buyback activity,” observes Amenta.
Sector-wise buyback trends, both for the latest quarter as well as trailing twelve months, are shown in the charts below:
Q2 2014 a record for the ratio of buybacks to free cash flow
Misallocation of free cash flows to buybacks instead of investing in the company’s business has long been a grouse of buyback critics.
Well, Q2 2014 outdid their worst fears. While free cash flow (defined as operating cash flow less capital expenditures and dividends) has shown a declining trend in recent years, buybacks have kept up their momentum.
According to Amenta, free cash flow TTM Q2 growth fell to -14.4% in 2011, 0.7% in 2012, and -12.1% in 2013. Against this, TTM buyback growth was found to be 66.4% in Q2 2011, 12.2% in Q2 2012, and 2.7% in Q2 2013.
“As a result, the ratio of buybacks to free cash flow has risen steadily from 25.3% in Q2 2010 to a post-recession record of 82.2% in Q2 2014,” remarks the analyst.
This phenomenon is brought out well in the chart below.
For all the criticism of buybacks, however, the report is categorical on their salutary effect on companies’ stock prices.
“Companies with the highest buyback yields have outperformed all other groups since 2005,” observes Amenta. “The first quartile of stocks by buyback yield has averaged a monthly return of 0.82% on an equal-weighted basis, which compared to average monthly returns of 0.74% and 0.69% for the second and third quartiles.”