Share buyback has to be done properly to create desired value

Photo courtesy of Andy on Flickr

Photo courtesy of Andy on Flickr

Rob Swystun, Pristine Advisers

Share buybacks for companies can be great for both the company and shareholders. Simple rules of supply and demand tell us that if a company buys back shares, this leaves fewer shares available in the marketplace, which makes those shares more valuable because the company’s net income is spread over fewer shares. Plus, having fewer shares available means the share price should theoretically go up.

In fact, driving up share price is usually the impetus behind company buybacks.

But, buybacks shouldn’t just occur for the sake of it. As reported by The Motley Fool’s Adam Levine-Weinberg, according to the patron saint of investing, Warren Buffett, four important criteria should be met:

  1. The company must have enough surplus cash to fund the buyback.
  2. The buyback shouldn’t interfere with the operation of the company.
  3. The company shouldn’t have to take on excessive debt load due to the buyback.
  4. The stock needs to be clearly undervalued.

1. Having adequate liquidity seems like an obvious condition. Just like us, a company needs to have the cash in order to make any kind of purchase.

2. Also like us, sometimes, a company has to scrimp and save in order to get what it wants. But, if a company is skimping on the capital investments that it needs to stay competitive just so it can buy back shares, it may be hurting itself in the long run.

3. If buybacks affect a company’s borrowing ability and thus impact how they run their business, then the buyback isn’t worth it, according to Buffett.

4. And then there’s that last requirement. But, how do you know if the stock is clearly undervalued? Buffett recommends figuring out a “conservatively calculated” intrinsic value.

Levine-Weinberg interprets this to mean that a company should take an honest ego-free look at its future business prospects and stock price compared to its competitors. If, and only if, the stock is obviously undervalued, then a buyback may be in order. If it’s on the lower end of the spectrum, but still within range of its competitors, the company should look to make improvements and try to bolster its value naturally.

Live and Learn

So, what happens when you don’t bother with these criteria and just buy back stocks for the sake of buying them back? You end up “pulling a Netflix” (also known by its less catchy title as “costing your current shareholders billions of dollars”).

Netflix management wasn’t particularly discerning when it came to buybacks in 2011. If the company had excess cash, it repurchased stock regardless of the price, which means they weren’t making any effort to ensure they weren’t overpaying for their own stock. (They could have just as easily gotten rid of some of that cash by giving out a dividend.)

But, as it turns out, in 2011 Netflix shouldn’t have gotten rid of their excess cash, period, because the company ended up desperately needing that cash.

Y’see, in quarters 1-3 of 2011, Netflix spent $200 million buying back 900,000 shares. But, its subscription price increase during the summer angered its customer base, causing a backlash and its international expansion ended up costing the company more than it initially calculated.

This left Netflix scrambling to turn a profit so it decided to raise money in the fall of 2011 by selling 2.86 million shares at $70/share, for a total of $200 million.

So, by mathing the numbers, we can see that Netflix bought 900,000 and then sold 2.86 million of the same shares just months apart for the exact same amount of money, essentially giving away about 2 million shares. Those 2 million shares, by the way, are worth over $800 million at their current market price.

Netflix also issued $200 million of convertible debt in late 2011, which eventually converted to another 2.3 million shares. These shares are worth about $1 billion today, a gain of nearly $800 million for the holder.

“By spending freely on share buybacks when it should have been bolstering its balance sheet, Netflix was forced to raise capital on extremely bad terms, costing shareholders more than $1 billion,” Levine-Weinberg sums up this woeful tale of buybacks gone awry.

There are lessons here for both management teams and investors. For management, don’t spend beyond your means and make sure you retain enough cash and borrowing leverage to run the company (and get through any dodgy periods that may come up).

For investors, be a bit wary about a big buyback announcement. It may or may not be good news, depending on if the management team has done their homework and are only buying shares back if they are clearly undervalued while still retaining the requisite cash to run their company.

Properly executed buybacks can definitely create value for shareholders by taking a chunk of undervalued stock out of the market, thus driving up value of the remaining shares. However, a poorly executed buyback can destroy shareholder value. Buyer beware.

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One response to “Share buyback has to be done properly to create desired value

  1. Pingback: A look at three important trends in the financial industry |·

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