The nexus between US share options and share buybacks is one where great evil lurks, dear readers. I’ve banged on about it before and got very little reaction, but even after all that Baruch got very cross indeed this week, when he finally took the time to get round to looking at Cisco’s fiscal 4th quarter results (belatedly it is true). Wankers! he yelled when he had a look at the guidance on share count.
Basically, Cisco bought $600m worth of its own stock in the quarter. This is a lot of money, obviously, about 30% of the net profit for Q4. The average number of shares out didn’t decline from Q3, which is odd, but potentially explainable if Cisco bought back all those shares towars the end of the Q. Except they also guided to a flat share count next Q. What the fucking hell did they do with that $600m then? Answer: the management used that money, shareholders money, to enrich themselves and their colleagues and hoped we wouldn’t notice. By and large, we haven’t.
Prof Lazonick of UMass sort of has, in a recent article for Business Week (HT Abnormal), but at the same time he misses the true perniciousness of share buybacks. He thinks they are merely a waste of money, which could be used for something more wholesome than merely enriching shareholders. The Prof points out that in the past few years IBM bought back lots of shares as it replaced good old American workers with Indians (apparently that is a Bad Thing because Americans are Better People). Drug companies buy back shares wastefully, yet argue that they are strapped for cash enough that it would be a Bad Thing to regulate drug prices. Now-bankrupt or government-supported companies like GM and the banks wasted loads of money that could have staved off ruin by buying shares. From the perspective of class warfare then, which is where Prof Lazonick seems to be coming from, share buybacks are a weapon for use by fat cat capitalists to screw the workers and should therefore be banned. If only they did enrich shareholders.
While we can disagree on the class warfare thing, however, he and Baruch are each others’ running dog; both our conclusions are the same, which is that Something Should be Done about shitty buybacks. And Prof L. gets close to the heart of the matter when he says:
It is the executives themselves who frequently benefit from price boosts generated by repurchases—by selling their personal shares after exercising stock options
Close, but not quite the banana, however.
Managers such as Cisco’s play on the market’s obsession with EPS. An estimate of EPS is “the number” a company has to beat each quarter. The holy PE ratio uses EPS as the denominator. Despite the fact that it is a constructed thing, an approximation of real economic returns and does not mean net cashflow, EPS is the arbiter of shareholder value, and a smart CEO/CFO will manage what he publishes so as to never print a sequentially lower EPS and always try and beat analyst EPS estimates by just enough. Cisco had a very improbable run of about 10 quarters this decade when every quarter’s EPS beat analyst consensus by exactly 1 penny. Who said management was an analogue process, inherently unpredictable?
However, a smart CEO/CFO also knows he only has a very short time in the hotseat to become mind-bogglingly rich. So he also needs to pay himself a LOT of money. This often looks bad, so he dresses it up in the language of incentives, maximising shareholder return etc etc. Share options are ideal for this, as they ostensibly align everyone’s interests. So the CEO/CFOs give themselves boatloads, and in order to keep them sweet, give planeloads to the level of management underneath, an effect which, in the case of CSCO, trickles down through every level of the company until it suffuses the culture. Wahey, share options for everyone and the secretary’s dog.
Only one problem: getting you and all your mates mind-bogglingly rich through giving them options on shares priced off EPS which you can manipulate upwards (to some extent) also tends, inconveniently, to mean the actual issuance of shares and the dilution of the holdings of existing shareholders. This lowers EPS, all else equal. Suddenly your EPS growth, which often determines the level of your PE multiple, no longer looks so hot, and starts to drop from 20% to maybe 15%. This is very bad. Rule of thumb is that PE : EPS growth rate equals 1, so off a $1 EPS your share price will be $15 not $20, a full 25% lower. That’s a lot of lost options profit and the analysts are starting to downgrade, the hedgies sniffing around you as a valualtion-based short. Whatchagonnado?
Simple, dur brain. Buy back the stock you just issued! No more EPS dilution, and hey presto, you can even present it as a return to shareholders, schmucks that they are just looking at the EPS, not the net debt position and enterprise value of the firm, even though that eventually determines the value of their investment. Apparent growth rate, PE and stock price are back to “normal”, 20%, 20x and $20 respectively, those $10 strike employee options are now $10 in the money, not $5, so you just doubled your return off a 25% boost to the share price, and isn’t leverage wonderful. You happy, shareholders happy and you look great. Who loses? No-one.
Of course, that’s a total lie. In reality you are just robbing Peter to feed Paul; you’re issuing stock at $10 and buying it back at $20. This is not generally thought of as investment best practice. Who loses, who pays that $10, is the company treasury and the dumbass shareholder whose cash pile held in the company is shrinking relative to what it should be — only he’s too stupid to notice.
What also is clear is that the economic return and thefore the fair value of a company like Cisco is wildly overstated by pricing it off EPS. It is impossible to think of Cisco no longer issuing share options; it would spark an employee revolt. The buttoned-down blue shirt, chino wearing and loafer-shod employees would unionise, the best would move to Juniper. Effigies of John Chambers would be burned in the parking lot. Issuing options is now a cost of doing business in the same way that paying workers a salary is. Let’s take that $600m they spent on fake buyback this last Q. Because the share count stayed flat we know they needed to spend that much to get to zero dilution, ie that was the value of the stock issued to meet options obligations the 3 months to July. We don’t know what the strikes of those options were. They could have been $10, which means they may have got half that $600m back from the employees when their options vested (they have to pay for the option stock they sell, remember). It might be more, it might be less. That means Cisco had effectively to pay its employees $300m in Q4, a sum of money which they hid by buying back $600m worth of shares. They overstated their earnings by about 15%.
In effect, share buybacks resulting from option issuance destroy value, not boost it as Prof. Lazonick implies. Take the example of IBM, which he says spent $73bn on stock repurchase from 2000 to 2008, half the current and then-market cap (it happens to be the same, about $155bn). They have net debt of about $13bn according to Wolfram Alpha. During that period, despite having bought back half the market cap in money, the shares in issue have only fallen by about 23%. Not a highly efficient buyback from any perspective, unless you are on the receiving end of options. Sure, had there been no buyback at all, the number of shares would be way higher, EPS lower as a result. But the company would have an astonishing net cash position of $60bn! Now that would be worth something, especially over the last downturn.
Personally I groan when I see a US company buy back shares. It is a pity, because sometimes the buybacks are actually effective. European companies don’t have the same culture of share option issuance, and so far I have trusted that buybacks there are actually the tax-effective return to shareholders they should be, in theory at least.
What is the Thing that Should be Done about all this? Frankly that’s not my business. My job as a fund manager is not to remake the world, rather to understand it and exploit it. But there needs to be clearer understanding of this issue on the part of stock exchanges and regulators, not so as to ban it, but for it to be explained to shareholders just what is being done with their money. They above all should change their focus away from pure EPS, and add consideration of cash flow and balance sheet to how they determine value, and for this they need the sell side to help them. As these guys are total suckups to corporates, I am not hopeful: it’s funny, ask a US analyst for a model and he sends you just the P&L. I don’t expect my peers to understand the point I am making here, or care even if they do, so much so that I own CSCO stock, even though I feel the actual economic value of the company is overstated; it is still cheap on EPS, or a cashflow-before-stupid-buyback basis. I dumb my analysis down because I know it is unlikely sufficient critical mass will ever be generated to overturn this state of affairs. It will probably need another crisis.
Every industry has its dirty secret which we all sort of know but don’t like to think about. The dirty secret of newspapers is (or was) that far from being ever-vigilant watchdogs of the public interest they are (or were) run by hacks with the sole aim of shoving as many adverts under our noses as possible. The dirty secret of US healthcare is the systemic corruption and extreme profit margins. The dirty secret of equity markets and corporate governance is how rewards are skewed in favour of company managements, who hold an incredible informational advantage over every other participant and who make out like bandits, whether shareholders win or lose.