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Buy high?

Stock repurchases may no longer be the bullish indicator they once were.

Like many things on Wall Street these days, stock buybacks ain't what they used to be.

Historically, corporations have repurchased their own stock from the public for two reasons: to return excess cash to shareholders and to prop up flagging share prices. Now companies are buying back shares primarily to support the exercise of options they granted as executive compensation, most often during the heady days of the bull market.

"The majority of buyback activity is going to satisfy options obligations," says Howard Silverblatt, a market equity analyst at Standard & Poor's.

After the stock market rally kicked off last summer, many companies had to scramble to repurchase shares. Cisco Systems increased an existing $13 billion buyback program to $20 billion in September. Home Depot and Kraft Foods announced buybacks of $1 billion and $700 million, respectively, in December. Merrill Lynch & Co. last month announced a $2 billion repurchase.

Through mid-February 2004, U.S. companies had announced 43 repurchases worth a combined $30.9 billion, setting a pace for the most active year since 1997. U.S. companies bought back just $138.8 billion last year, 35 percent less than in 2000, according to New York research firm Dealogic (see graph).

That activity signals a decisive change from the bear market of 2002 and the first half of 2003. Companies looking to prop up their battered shares, the traditional spur to buybacks, should have jumped at the chance when the market bottomed out. But they didn't.

One reason for this decline is that dividends have become a more attractive way to distribute excess cash to shareholders. Indeed, demand for safer, dividend-bearing shares rose during the bear market. Then last year President George W. Bush gave the trend a shot in the arm by slashing the tax rate on dividend income to equal that imposed on capital gains. A wave of companies increased dividends, while others, like Microsoft Corp., began to pay them for the first time.

"All of these developments made dividends look more attractive relative to share buybacks," says Malcolm Baker, an assistant professor of finance at Harvard Business School.

But the recent boom in buybacks doesn't mean that corporations suddenly deem buybacks more advantageous than dividend payouts. Many companies simply need massive blocks of shares to satisfy options exercises. With the Nasdaq composite index having gained more than 80 percent from its low and the S&P 500 index up nearly 50 percent, options that had long been worthless are now in the money, and holders want to cash in.

That leaves many companies with a choice: Issue new shares, which existing owners often resent because it dilutes their stakes without raising capital that can be reinvested in the corporation, or buy back shares from the public.

"Stocks have gone up to the point that a lot of options are above water," says Silverblatt, the S&P analyst. "So companies have started to increase their buybacks."

That means that repurchases may no longer be a way for corporations to return cash to investors while signaling to the market that their shares are undervalued. Rather than taking shares out of circulation -- and thus potentially raising earnings per share and stock prices -- options-motivated buybacks result in the repurchased shares being sold again by options holders. Some investors appear to be catching on and are none too pleased.

Cisco, for instance, has been criticized by shareholders who regard the data networking giant's buyback as little more than a way to cover executive compensation costs; some would prefer receiving a dividend.

"It's not just about offsetting stock options," says a Cisco spokeswoman, noting that during the three months ended January 31, Cisco bought back 85 million shares while its employees and executives exercised only 42 million options.

Although not every buyback is sparking such controversy, it seems certain that the days of repurchase announcements being universally cheered by the market are long gone.

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