Soaring Buybacks, Sagging Returns

Performance of share repurchase programs continues to slip, but companies still fail to ask: Do they generate good returns for investors?


Krisztian Bocsi

A cash infusion last summer lifted the shares of Schaumburg, Illinois–based Motorola Solutions when private equity firm Silver Lake invested $1 billion in the telecommunications company in exchange for senior convertible notes. Press releases touted a new era at the company, which caters to the rising demand for public safety communications, its specialty since Carl Icahn pressured it into spinning off its once dominant cellular phone business in 2010 into a new entity, Motorola Mobility.

But an investment 11 times larger than the Silver Lake stake got considerably less fanfare at Motorola Solutions. Under a series of board authorizations beginning in July 2011, repurchases had trimmed the share count in half. The tab for the buyback program included $3 billion in the first nine months of 2015, in part to offset potential dilution should Silver Lake convert the debt to equity.

Motorola Solutions declares its buyback program a success. A spokesperson says the company spent an average of $56.91 for shares that trade now in the low $70s. But at Motorola Solutions, like at many companies, accountability on share buybacks suffers in the absence of rigorous benchmarks.

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Companies that regularly repurchase their shares seldom ask, much less answer, a pivotal question applied to other significant investments of shareholder capital: Do buybacks generate an optimal return on investment for investors that hold on to their stock? Never mind that share repurchase programs are now mainstream enough that an exchange-traded fund, PowerShares Buyback Achievers, tracks the performance of these companies. Returns on investment on buyback programs too often remain elusive.

To arm investors with the tools to conduct peer-to-peer evaluations, since 2012 we have been providing Corporate Buyback Scorecards, which measure and rank stock repurchase returns on investment. The calculations weigh underlying stock performance, after stripping out dividends and factoring in the timing of buybacks with respect to average price trends. Developed and computed for Institutional Investor by New York–based Fortuna Advisors using data from S&P Capital IQ, the current Corporate Buyback Scorecard, for the third quarter of 2015, examines 299 Standard & Poor’s 500 index companies where buybacks retired more than 4 percent of market capital or exceeded $1 billion over eight quarters through September 2015.

Buyback performance has declined since the fourth quarter of 2013, when a measure we call buyback ROI nearly topped 30 percent. In the third quarter, market volatility punished buyback ROI. The scorecard records the steepest one-quarter drop in the performance measure, to 5.2 percent from 14.9 percent the previous quarter.

Overall buyback rankings paint a broad picture of performance, but we can also drill down into company quintiles and industry sectors. It is axiomatic that buybacks improve earnings per share by reducing share count, all else being equal. But breaking down the most recent data by quintile shows that buybacks that retired the smallest percentages of market capital during the quarter packed the most punch in terms of median improvements in EPS.

Conversely, big buybacks did not guarantee equivalent improvements in median EPS. Instead of signaling confidence, some may be viewed as warnings. Top-quintile buybacks by size retired 21.3 percent of initial market capitalization over eight quarters and showed an 11.0 percent decline in EPS over that period. In contrast, companies in the bottom quintile by size, retiring 4.3 percent, saw a 17.4 percent gain (see chart).

“Many investors are wowed by buybacks, especially in these times of low interest rates, because of the automatic increase in earnings per share,” says Fortuna CEO Greg Milano. However, Fortuna found a reduction in price-to-earnings multiples, on average, among the companies that conducted buybacks. “EPS growth [from buybacks] was worth about half as much as EPS growth from operations,” he says.

Increasing buyback activity invites scrutiny. The current Corporate Buyback Scorecard consists of results of share repurchases going back two years and worth in total some $1.1 trillion. In dollars, the third quarter of 2015 outpaced every quarter since March 2013, with the exception of the first quarter of 2014.

Without the means to fine-tune verdicts, institutional investors tend to employ anecdotal experience and rules of thumb to assess the merits of buybacks. “Companies that have less solid foundations may use buybacks as a way to support the stock or make announcements that they think the stock is undervalued,” says Claritas Capital co-founder John Chadwick: “Those are fundamentals we would not want to be part of, long-term.”

Flaws often attract more attention than virtues. “A bad buyback is when a company in response to the pressure from an outside activist adds debt and leverage to repurchase shares,” says co-chief investment officer David Pearl of Epoch Investment Partners.

Pearl singles out Midland, Michigan–based chemical company Dow Chemical Co., which recently announced a megamerger with Wilmington, Delaware’s DuPont, for praise. He cites the fact that Dow has paid out regularly increasing dividends since 1912, sets leverage at a satisfactory level and meets its targets for a repurchase program in terms of return on capital and free cash flow. “That checks all the most important boxes for us,” Pearl says.

Could Dow improve the returns that buybacks achieve? Ranked No. 195 on the current scorecard, Dow recorded a negative 2.0 percent in buyback ROI, lagging the median for the Materials industry group by 150 basis points. Dow trailed top buyback ROI at sector leader Sealed Air, based in Charlotte, North Carolina, by 46 percentage points. Unlike at Dow, execution at Sealed Air lifted buyback ROI above underlying total shareholder return.

T. Rowe Price asset manager Sudhir Nanda applauds slow and steady buybacks, citing an example of managers who retired 40 percent of their company’s stock over ten years. “They may not always have bought at lowest price,” Nanda says, but year by year shares went out of circulation, with favorable impact on EPS: “To me, this management is very prudent with the way it deploys capital.”

Observers widely agree that robust free cash flow, an absence of investment alternatives and consistent strategic objectives can justify buybacks. Companies should be cautious when comparing buybacks to other investments: If a billion dollars invested in a new product goes south, the only way for companies to recoup losses is to redeploy remaining assets elsewhere. If stock prices rise above purchase prices before some terminal event, say a bankruptcy or a merger, buybacks can appear to have redeemed themselves, despite underperformance in the interim. Also, remaining shareholders acquire a larger claim on earnings — along with added risk in a more leveraged company.

There are signs, however, that claiming that no better alternatives exist for the cash or unused debt capacity than buying shares back takes some companies off the hook too easily. Instead of assuming the responsibility of generating long-term growth, managers hasten to meet short-term goals, sometimes incentivized by their own short-term compensation considerations.

“Saying willy-nilly that all excess capital should be returned to shareholders in the form of buybacks is oversimplifying the options that cash presents to management,” says Brian Angerame, a managing director and portfolio manager at New York–based ClearBridge Investments, an asset management arm of Baltimore asset manager Legg Mason that emphasizes long-term growth in its portfolios. “It irks me no end when a management team says its top priority is to use buybacks to offset dilution,” he adds. “Have they ever thought whether issuing those options was the right thing to do?”

Whatever their motives, managers nearly always express enthusiasm when they announce buybacks. Informed shareholders, however, are skeptical. “It’s the least bad alternative when you don’t want to sit on cash,” says Lawrence Pfeffer, a senior analyst at Nashville, Tennessee–based money manager Avondale Partners.

Companies that took that least bad step post mixed results on the latest scorecard, which covers a period characterized by volatility and churn in the markets, with little in the way of growth. Health care equipment and services fared best: The quarter’s median buyback ROI was 26.1 percent. More than $54 billion in buybacks produced a wide range of positive buyback ROI at individual companies, from 49.4 percent at Bloomfield, Connecticut–based insurer Cigna a razor-thin .1 percent at Varian Medical Systems, the Palo Alto, California–based medical devices company.

Cigna and two other health care companies hit the top ten in overall buyback ROI rankings. Cigna’s buyback program stresses flexibility. In its latest 10-Q, Cigna disclosed a share repurchase program that it can suspend at any time, “generally without public announcement,” notes the company. At times when Cigna cannot trade shares, executives may avail themselves of 10b5-1 trading programs, which provide a safe harbor from insider trading violations.

Beleaguered after a steep drop in oil prices, energy companies, not surprisingly, occupy the sectoral basement in buyback ROI. The industry spent more than $65 billion to buy back shares and recorded a negative 13 percent in buyback ROI. Falling prices for oil and natural gas pummeled returns, including ill-timed moves to repurchase shares in expectation of a rebound in early 2015.

The oil patch was replete with disasters, with one exception: the refiners. San Antonio–based refiner Tesoro Corp. not only leads its sector, it ranks No. 2 overall in buyback ROI. An enviable 53.8 percent buyback ROI got a boost from generally rising stock prices and an easing off in buybacks.

Darden Restaurants, the Orlando, Florida–based owner of casual-dining chains, tops the ranking at 55.8 percent in buyback ROI. Its collection of brand-name restaurants, including Olive Garden, LongHorn Steakhouse and Capital Grille, attracted diners and investors, and its buyback program rode a rising share price.

Although buyback ROI at Motorola Solutions lagged 185 companies on the full list and six in its own sector, Technology Hardware and Equipment, two key measures warrant special attention. Its buybacks over eight quarters through September 2015 reduced shares outstanding and market capitalization by larger percentages than at all other companies in the ranking. Buybacks trimmed Motorola Solutions’ share count by 31.8 percent and its market capital by 48.9 percent. The medians for the sector ran 5 percent and 8 percent, respectively.

Shrinking the number of Motorola Solutions shares lent some support to falling EPS, which slipped by 45.1 percent as earnings posted a 63 percent decline. At 0.5 percent, buyback ROI at the company fell short of its industry median by 12 percentage points. Surging performance at Apple, in Cupertino, California, pushed the computer maker’s buyback ROI to 26.5 percent, making it the sector leader. Leaving aside Apple, where the magnitude of its buyback program distorts comparisons, five other companies beat Motorola Solutions’ buyback ROI: San Jose, California–based Cisco Systems, Sunnyvale, California’s Juniper Networks and Seattle’s F5 Networks all surpassed Motorola Solutions by more than 11 percentage points. Amphenol Corp., headquartered in Wallingford, Connecticut, and Switzerland-based TE Connectivity posted margins of 9.4 and 2.2 percentage points, respectively.

If Motorola Solutions had matched Cisco’s 13.8 percent buyback ROI, the company would have added $447 million in value for shareholders, notes Fortuna vice president of research Joseph Theriault.

Pressed during a third-quarter earnings conference call for details on its buyback strategy by Cowen Group equity research analyst Fahad Najam, Motorola Solutions responded with generalities. CEO Greg Brown confirmed that the $3.5 billion target for 2015 was unchanged, already achieved in large part by a $2 billion modified Dutch auction tender offer in August 2015. “We obviously executed on the tender offer and took a big chunk of shares out this past quarter,” Brown said. He added that Motorola earmarks 50 percent of its operating cash flow for repurchase or M&A, 30 percent for dividends and 20 percent for capital expenditures.

To estimate the consequences of well- or poorly timed repurchases, buyback effectiveness captures the difference between buyback ROI and underlying total shareholder return, which the Corporate Buyback Scorecard calls buyback strategy. The median buyback effectiveness for all ranked companies in the third quarter slipped further into the red at a negative 5.7 percent, a steady descent since hitting its nearly 10 percent top in early 2013.

A well-traveled analogy illuminates the dilemma that buybacks pose. Say two of ten partners in a closely held firm decide to retire. “You just use last year’s cash flow to buy out the partners. Now you own an eighth of the company instead of a tenth,” says Epoch Partners’ Pearl.

That’s an upbeat way to look at it. As Fortuna’s Milano says, if remaining partners can justify their optimism, they’ll view the buyout — in a public company, a share buyback — as an excellent deal. However, a grim outlook for the business may cast the expenditure in a different light. If the business stumbles, buying out partners at a peak price won’t look very smart. Managers and investors should view buybacks the same way, Milano says.