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November 14, 2012
Thanks, Greg. Although thoughtful points about Mr. Safety and Ms Rollercoaster are well taken, I agree with you. Perspective, framework and opportunity cost underscore the merits of a buyback ROI benchmark that informs us whether a buyback has been desirable for the company and its remaining shareholders.
Part 2 – this is a continuation of my prior post
Opportunity Cost: When we compare Buyback ROI to the same hurdle used for capital expenditures or acquisitions we INTRODUCE an opportunity cost to the decision process that was typically not there before. You say “presumably we trust management to determine whether they have positive-NPV projects to invest in” but in fact it is the reduced reinvestment rate back in the business at a time when companies are generating record return on capital that has me most troubled. I believe many management teams have become too wowed by the enticing quick EPS boost they get from buybacks that they are under-investing in their future and I believe this is one of the more important controllable reasons why the S&P 500 trades at such a discounted multiple versus recent times. Our research shows across the market that the companies that reinvest a greater percent of the cash they generate back into the business tend to deliver higher total shareholder return and it is my view that buybacks are crowding out good investments in some companies.
Other Insights: The impact of buybacks on shareholders is poorly understood by many so here are some highlights from our other research. Companies that use more of the cash they generate to buy back stock tend to have lower revenue growth and worse share price performance. This is partly driven by the reduced (crowded out) reinvestment for the companies buying back more stock but it also results from the fact that the more a company grows EPS from buybacks, the more their Price/Earnings Multiple tends to DECLINE.
These are very good questions and comments, and there is more to story so please feel free to contact me if you would like to discuss further.
Gregory V. Milano
Chief Executive Officer
This is a very good post as I am sure it raises questions others have. It is really several different comments and questions so let me address them one by one. I will submit as two comments so the words all fit.
Perspective: The first section points out that the return to a shareholder that sells into a buyback is unaffected by the performance of that stock after they sell it. That is completely true but misses the point. The Buyback ROI aims to inform us whether a buyback has been desirable for the company and the remaining shareholders. Buyback ROI works just like any other ROI on a capital investment or an acquisition to tell us if it turned out well for the company and the remaining shareholders.
Framework: You suggest Buyback ROI offers no framework for decision making but I respectfully disagree. A buyback involves two decisions. First the company must decide if capital should be distributed to shareholders and this normally relates to whether or not there are desirable investments available (more on this below). Second if they decide they should distribute capital they must decide between a buyback, a special dividend or a higher ongoing dividend. Buying their own shares instead of paying a dividend involves the very same valuation analysis and decision process they go through when they consider an acquisition or any other investment. Are they buying something fundamentally worth more than they are paying? When the price is high they can simply pay a special dividend and avoid harming the remaining shareholders by buying out the selling shareholders at too high of a price. One would think management would be very good at this since they have full inside information but they tend to buy far more stock when its expensive and less when its cheap which tends to be bad for remaining shareholders. Buyback ROI can be directly used in advance to assess whether a buyback seems to be a good deal in exactly the same way they estimate the ROI of an acquisition.
Gregory V. Milano
Chief Executive Officer
I'm a bit confused. When a company returns capital to investors, which the investors subsequently invest _somewhere else_, how is the investor's return influenced by subsequent price changes of the original firm's shares?
Take two investors, Ms. Safety and Ms. Rollercoaster. They both invested in company Moderate. Say Moderate buys back their shares. Then three things happen:
1. Ms. Safety reinvests in Treasuries, and earns 1%.
2. Ms. Rollercoaster reinvests in Apple, and earns 50%
3. Moderate's own share price rises 10%.
What is the "buyback ROI"? Your method suggests 10%, but the investors (Ms. Safety and Rollercoaster) certainly don't realize that ROI. In fact the return enjoyed by the investors is independent of subsequent change in the price of Moderate.
Your ROI method seems to double-count the "investment": the capital that's returned is subsequently invested elsewhere -- Treasuries or Apple -- yet you suggest that we should _also_ include the return of Moderate, in which there is no remaining investment. What capital, exactly, are you calculating the return on?
There are at least two other issues with this "buyback ROI" approach. First, it offers no framework for decision making. Assuming management has no crystal ball, how can "buyback ROI" inform their decisions regarding capital allocation and return?
Finally, "buyback ROI" appears to violate the fundamental economic principle of opportunity cost. For simplicity, let's assume firms can do three things with surplus capital: reinvest in their own business, return to shareholders, or invest in Treasuries. Presumably we trust management to determine whether they have positive-NPV projects to invest in, and the underlying assumption in our discussion is that they do not. So we leave them with alternatives two and three. Are shareholders better served by the company's returning capital (for subsequent investment by the shareholder), or by the firm's investing surplus cash in Treasuries?
The "buyback ROI" approach suggests that companies should _time_ their capital return -- and of course any suggestion to time capital return means we suggest that management will at times retain capital to invest in Treasuries, rather than return that capital to shareholders for more productive uses. Is this what you're suggesting management do -- hoard surplus capital until the share price is expected to rise?
As an alternative framework for guiding decision making, perhaps we should return to corporate finance fundamentals. Recall that
A share buyback is equivalent to a special dividend plus a reverse share split
"Buyback ROI" would have us believe that we can calculate the "ROI" of a (special dividend + reverse share split). If we don't believe we can do this, then we don't believe we can calculate a "buyback ROI".
It's important to differentiate between the return _of_ an investment, and the return _on_ investment. A share repu
It is true that this study captures one picture out of many and as Steven Mintz suggested we had to pick a time period for the ranking. As of this year’s second quarter, NFLX’s Buyback ROI over its total buyback program (since Q2 2007) is 21% which is much better as noted but they still have a negative Buyback Effectiveness of -4.6% (They tend to buy more when the share price is above the longer term trend than below).
If we extend this analysis through this year’s third quarter, however, Buyback ROI drops to 11.6% because of NFLX’s stock price decline and Buyback Effectiveness stays negative at -7.6%.
The two-year study was chosen for the published ranking and over this period it demonstrates that NFLX’s use of $257 mm for repurchasing shares in this period did not create value for its shareholders. From the shareholder’s perspective it is really no different than if they used this capital to make an acquisition that subsequently declined in value the same amount.
Thanks. The comment is welcome and valid and also underscores the value of computing buyback ROI. The window matters, of course, just as windows affect other performance measures that investors routinely rely on -- from annual revenues to net income. Now at last investors can probe and debate the merits of buybacks using common benchmarks that hold managers to account. If this measure can be improved, we invite suggestions.
From Ronald Fink, Executive Editor of II:
Fair point, and one made in the sidebar in connection with another company, FLIR, that underperformed the S&P 500 on this measure. So I've asked Greg Milano of Fortuna Advisors to put Netflix's performance into a longer-term perspective.
I think the authors of the study would have a different conclusion about NFLX if they went back further. From 2007-2011, NFLX spent $1 billion buying shares, at an average price of $45.16.
NFLX Share Repurchase ($ in millions)
Year $ amount Shares avg price
2007 100.0 5 $21.00
2008 100.0 4 $26.00
2008 100.0 3 $29.00
2009 175.0 4 $42.00
2009 149.0 3 $47.00
2010 210.0 3 $80.67
2011 200.0 1 $221.88
Total 1,034.0 23 $45.16
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