Ironically, he says companies tend to launch repurchase programs in times of crisis, when earnings soften and cash flow wanes. “As operating cash flow goes down, capital investment usually falls off,” notes Gentry. “That makes it more difficult to go through with a buy-back.”
When a fair number of companies begin reneging on their stated intention to buy-back shares, investors start to become inured to buyback announcements.
In essence, the novelty wears off.
Delicate, Very Delicate
If follow-through is crucial to the success of stock buybacks, so too is how a company pays for a repurchase program. Corporate finance executives often choose to borrow to repurchase shares because the coupon on the debt is tax deductible.
But if debt servicing starts to interfere with a company’s ability to generate consistent earnings and cash flow, a much-trumpeted buyback program can quickly start to resemble a millstone.
Not surprisingly, some bankers and analysts say debt-funded buyback programs are often a delicate affair. “Raising debt as a proportion of total capital is always dangerous,” stresses Lehman’s Willens. “It is precarious to have a high debt-to-cap ratio because there is no guarantee that the business will generate enough cash flow to service debt down the road.”
The danger-level varies according to the industry a business operates in. Companies in the consumer non-durable sector, for example, can sustain a higher debt-capital ratio because earnings in those industries tend to be more linear. “In those cases,” asserts Willens, “it wouldn’t be alarming to see debt-capital ratios in the neighborhood of 40 to 50 percent.”
On the other hand, managers at more cyclical businesses might be ill-advised to borrow money to fund a repurchase plan. Prudential’s Keon maintains that, based on historical patterns, buybacks may not be as effective for large-cap companies with a debt-to-capital ratio substantially over 50 percent.
Ultimately, a corporation’s bond rating may suffer if a buyback program raises the company’s debt-to-capital ratio high enough. If a company’s credit rating sinks low enough, thus jacking up borrowing costs, the positive impact of a buyback on earnings per share can be canceled out.
Even managers at cash-rich corporations need to think long and hard about stock repurchase program.
To show true faith in a company’s future prospects, some analysts say a repurchaser should make a tender offer for the shares, rather than an open-market repurchase. In a tender offer, the repurchaser agrees to buy all the shares in a buyback program very quickly — usually within twenty days. What’s more, the buyback is usually at a considerable premium to the trading price of a stock.
Not surprisingly, tender offers tend to produce more of a wallop than open-market buybacks. “The stock price reaction will be higher with tender offers than open market repurchases,” Buddington of Stern Stewart says.
According to Buddington, studies indicate that a company’s stock price jumps an average of about 4 percent after the announcement of open market repurchase. And the stock run up after a tender offer? Share prices rise as much as 16 percent after such an offer is announced, Buddington asserts. Announcements of tender offers that are financed with debt have triggered stock price increases as high as 22 percent.
But tender offers come with their own set of risks. The biggest worry: the fixed premium in a tender offer might actually turn out to be higher than the average premium paid over time in an open market repurchase. Hence, repurchasers have to be spot-on accurate in their market forecasts. “There is definitely an element of market timing to buy-backs,” notes Lehman Brothers’ Willens.
Of course, recent launchers of open-market buyback programs like PepsiCo and Home Depot could get beat up by market events as well. Says David Bonaccorso, an associate at Hoefer & Arnett, a stock brokerage and investment bank based in San Francisco: “Companies may be paying too much for their shares, even though they now appear to be at very attractive levels.”
Indeed, if the current stock market slide turns into a protracted slump, very few open-market buybacks will look like good deals for shareholders. “If the market settles at 15 and you bought back at 20,” notes Bonaccorso, “then you’ll have a bit of egg on your face when its all said and done.”