Stock buybacks are all the rage in corporate America. Companies in the Standard & Poor’s 500 index repurchased a record $325 billion of their own shares last year, a 64 percent leap from 2004, according to S&P. And there’s no sign of a letup. General Electric Co., for example, is following last year’s $5 billion in buybacks with an additional $9 billion in 2006; Procter & Gamble plans to buy $20 billion of its shares by midyear.
The rationale behind repurchasing is simple enough: Companies that generate mountains of cash but don’t spend it all should return some to shareholders. In practice, however, buybacks can be more expensive than they seem. Sopping up big blocks of stock can cost a bundle in brokerage commissions and drive up share prices dramatically.
Corporations are thus exploring alternatives to traditional open-market buybacks. One that’s becoming popular is the accelerated share repurchase, which accounted for $24 billion in buybacks in the past two years, according to Bear, Stearns & Co. In an ASR a brokerage house borrows enough shares to cover a company’s entire buyback program and sells them to the company all at once. The firm then takes several months to buy shares to cover its short position and splits with the company the difference between the price of the borrowed stock and the weighted average price of its short-covering purchases. If the brokerage makes money on the cover, it pays the issuer a rebate. But if it takes a loss, the company pays more.
Unlike open-market buybacks, which retire shares over time, ASRs provide an immediate boost to a company’s earnings per share. They also feature brokerage commissions of about 2 cents per share on the up-front purchase, instead of often higher rates for conventional buybacks, and lay off some of the risk of stock price movement onto the executing brokerage. Another benefit: Cash that the company puts up for the borrowed stock earns tax-free interest until the loan is repaid. And not least, ASRs prevent the disappointment investors can experience when companies announce big buyback programs but don’t complete them because costs mount over time.
“Companies that execute an ASR are providing a much stronger signal to the investment community than with an open-market purchase,” says Neil Kearns, who heads the desk at Deutsche Bank that executes ASRs for corporate clients. “It’s not just an authorization. It’s a commitment.”
Issuers can use derivatives to further allay risk. Early this year, Hewlett-Packard entered into a $1.7 billion “collared” ASR with BNP Paribas, in which the technology company used a forward contract to lock in a final execution price range, thus limiting the buyback’s ultimate cost.
Other brokerages are offering variations on ASRs that give them more flexibility to accelerate or delay their short covering if stock prices swing wildly (normally the brokerage’s buying is parceled out evenly over the term of the ASR). In return the firms give issuers guaranteed discounts on their final execution prices. In January healthcare software company IMS Health struck such an agreement with Banc of America Securities. The firm extended a 42 cents-per-share haircut on its final execution price to IMS, in return for the right to cut or extend the short-covering term.
