U.S. companies’ interest in buying back their stock is well-known, and it’s anything but waning. According to Calcbench, S&P 500 firms repurchased $166.3 billion worth of shares during the first quarter of 2018, up 18.7% from a year ago.
For a long time, companies have primarily performed regular open-market repurchases. However, a fairly new form of buyback ― accelerated share repurchases (ASR) ― has lately become quite popular.
Four months ago, The Kroger Co. entered into an ASR transaction with Goldman Sachs to buy 36.1 million of its shares in one day from Goldman for $1.2 billion (plus transaction fees).
Repurchased shares were immediately recorded in treasury stock, reducing the company’s total share count overnight by 4.2%. (Some actually refer to ASRs as “overnight share repurchases.”)
It would have taken weeks for Kroger to buy back 36 million shares on the open market with regular repurchases through a broker. That’s because the Securities and Exchange Commission limits open-market repurchases to 25% of a company’s past day’s trading volume under the safe harbor rule. The rule shields companies from liability for stock-price manipulation.
Executives seem to appreciate the quick completion of a repurchase through an ASR. For instance, the CEO of ONEOK Inc. noted in 2006, “By moving quickly to complete this accelerated share repurchase program, we create immediate value for our shareholders and eliminate the management distraction that would occur if we were to repurchase the shares over an extended period of time.”
Under an ASR, a company in essence contracts out a series of open-market repurchases to an investment bank. The latter receives an initial payment and immediately delivers to the company a large block of its shares, borrowed from institutional investors such as mutual funds.
To replace borrowed shares, the investment bank gradually buys the company’s shares through a number of regular market transactions during the few months following the ASR transaction.
From an accounting perspective, it doesn’t really matter how quickly the investment bank completes stock purchases on the market. But as the effect on shares outstanding is reflected immediately in the company’s books, companies generally realize a quick boost in earnings per share.
ASRs do not involve offering a premium for repurchased shares. The transaction between an ASR firm and its investment bank is conducted at the current market price, increasing the attractiveness of ASRs for repurchasing firms.
Apple, Big Lots, HP, McDonald’s, Pfizer, and United Technologies are among the companies using ASRs to return large amounts of cash to shareholders. Notably, Apple spent $68 billion on ASRs between 2012 and 2017. To put that figure into context, the company paid $60.7 billion for dividends and $98 billion for open market repurchases during the same period.
Why have ASRs become so popular? Managers often argue that ASRs help firms generate and enhance shareholder wealth by enabling them to rapidly return cash to shareholders.
“This accelerated share repurchase demonstrates our commitment to delivering increased value to shareholders in the short term,” said the CEO of Merck Inc. when announcing the company’s ASR in 2013.
Another commonly cited reason for ASRs is to communicate to shareholders managers’ confidence in their companies’ prospects. The CEO of Flower Foods Inc. said in a statement in 2016: “The accelerated share repurchase is a further expression of confidence in Flowers’ cash flow, long-term prospects, and ability to generate additional shareholder value.”
To test the validity of managers’ claims, I performed a study, forthcoming in the Review of Accounting and Finance, that examined 293 ASR transactions initiated during the 2004-2011 period. The study found that the firms making these deals, on average, reported improved operating performance (as measured by operating income divided by total assets) during the post-ASR period.
That result is consistent with the argument that ASRs are a signal of better future performance. Nonetheless, it does not hold true for every ASR firm.
Notably, the study documents that 29% of ASR firms (EPS-suspect firms) in the sample would have missed the analysts’ EPS targets had they not undertaken the repurchase. In other words, such firms appear to use the repurchase transaction opportunistically to meet or beat analysts’ EPS targets rather than communicate the manager’s optimism about the company’s prospects.
Supporting this view, improved operating performance does not follow ASR announcements by EPS-suspect firms.
Who are the EPS-suspect companies? The study identified them by looking for those in the sample that met or beat analysts’ consensus EPS forecasts within a tight range (i.e., 0-5 cents) but would have reported below-target EPS in the absence of an ASR, which helps managers boost EPS by reducing the company’s shares outstanding.
Certain companies were more likely to use ASRs for EPS management. Among them were firms that provided their CEOs with EPS-linked bonus payments and those that consistently beat EPS targets for the past three years
Thus, evidence suggests that increasing compensation and maintaining reputation are relevant motivations for some managers’ opportunistic use of ASRs.
Do the market participants overlook the impact of ASRs on reported EPS? If so, managers can benefit from using ASRs as an earnings management device.
The study found that analysts reacted to ASR announcements by increasing their short-term EPS forecasts. However, that effect was short-lived. Analysts later revised their EPS forecasts downward as the earnings announcement date approached, indirectly facilitating firms’ use of ASRs to meet or beat consensus forecasts.
Investors appear to see through the EPS management role of ASRs. By comparing EPS-suspect ASR firms with control ASR firms (which met or beat EPS targets regardless of an ASR), the study showed that after controlling for other relevant factors, EPS-suspect firms earned 2.1 percentage-point lower stock returns around the announcement of earnings following the ASR.
Interestingly, in only 3 out of 293 cases did compensation committees report taking into account the EPS impact of an ASR when deciding whether EPS targets were achieved. But, although using ASRs to meet or beat EPS targets does not seem to help firms generate a positive investor reaction at earnings announcements, it likely helps some managers secure their bonuses and maintain their reputations.
The study concluded that while ASRs can enable managers to communicate to investors that future prospects of their companies are strong, careful consideration should be given to the timing of an ASR.
Undertaking an ASR when the company is in danger of missing EPS targets may be interpreted negatively by investors (as a sign of potential EPS management motivation) rather than as a positive signal of better future performance.
Also, corporate boards need to be cognizant of different managerial motivations behind ASRs when deciding on policies related to repurchases and executive compensation. The opportunistic use of ASRs by managers to quickly boost EPS is prevalent, and these actions do not enhance shareholder value.
Ahmet Kurt is an assistant professor of accounting at Suffolk University’s Sawyer Business School in Boston.