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Buyback Binge Now Creates Big Hangover

Think you're doing badly in the stock market? Hewlett-Packard has lost about $4.2 billion on the investment its executives should know the most about -- its own stock.

The company spent $8.2 billion from November 1998 through this past October buying back about 128 million of its own shares. Since then, due to the slowdown in the personal-computer business and the bear market in technology stocks, Hewlett-Packard's shares have plunged in value, dropping more than 50% to $31.63 at 4 p.m. Friday in New York Stock Exchange composite trading from the $64.17 the company paid, on average, for its own stock.

So at last week's closing price, the stock that Hewlett-Packard bought would now be valued at $4 billion -- or $4.2 billion less than HP paid.

Hewlett-Packard has plenty of company. AT&T, Intel and Microsoft all have bought back shares in the past two years whose collective value has fallen by more than $1 billion. Corporate America has gone on a record buyback binge, with companies repurchasing $123 billion of their own stock last year and another $91 billion in the first nine months of this year, compared with just $10 billion in 1991, according to data compiled by Rick Escherich, a managing director at J.P. Morgan.

Buying back stock when it is cheap can boost shareholder value, of course. But buying back stock when it is expensive is "just plain dumb," says Bill Nygren, manager of $4 billion at Oakmark and Oakmark Select funds. He also labels companies "dumb" when they say they buy back their stock no matter what the price. "Like a lot of other concepts, share repurchase has been used by a lot of people who don't understand it," Mr. Nygren adds.

In fact, corporate America's attitudes continue to be the reverse of investment theory: Now that stocks are falling, companies are cutting back instead of revving up their repurchases to take advantage of the cheaper prices. A study by Bridgewater Associates finds that announced buybacks have plunged this year. (The large volume of buybacks that has occurred this year is largely due to buyback plans announced in prior years.)

A spokeswoman for Hewlett Packard, Palo Alto, Calif., says its stock buybacks are "an efficient way to use cash," adding that it regularly buys back stock to offset dilution from the millions of shares that are issued through employee stock options. In those instances, "it doesn't matter what the stock price is," the spokeswoman says. But she says the company increases its buying at times that it thinks its stock is undervalued.

Renowned investor Warren Buffett, chairman of Berkshire Hathaway, is among the doubters of the buybacks-are-beautiful crowd. In his most recent letter to shareholders, he notes that in the mid-1970s, when many stocks traded below their intrinsic value, "the wisdom of making these [share repurchases] was virtually screaming at managements." But "that day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price."
 

Critics also say that buybacks can serve management's interests. Corporate managers sometimes direct their companies to buy back stock -- instead of paying dividends or making investments in their business -- "because they have options that are tied to the stock price," says Ralph Wanger, co-manager of $3.6 billion Liberty Acorn Fund. "They are working on their own short-term economic welfare." The problem for shareholders comes when corporations overpay for their own stock: "Obviously, if you buy any asset at more than its value, it's a bad idea, whether it's a stock or a glass of beer."

Mr. Buffett, in his letter, also faults buybacks made to offset option-related stock sales. Investors, he notes, don't like to buy high and sell low, but in this instance, "managements ... seem to follow this perverse activity very cheerfully." Put another way, "buying dollar bills for $1.10 is not good business for" the remaining shareholders who stick around.

AT&T furnishes one striking example of a company that made overpriced buybacks. In early 1999, AT&T, New York, paid nearly $4 billion to buy back shares, part of a $10 billion share repurchase begun in 1998 to reduce earnings dilution from the acquisitions of cable companies TCI and Media One Group. Since 1998, AT&T has bought a total of 219.1 million shares, and their value is now lower by more than 50% from the average buyback price -- or more than $5 billion.

Meanwhile, the phone-and-cable giant is saddled with $62 billion in debt, much of it added when it bought those cable companies at high prices. To satisfy the concerns of credit-rating agencies, it is now selling off assets to pay down some of that debt.

Its decision to spend $10 billion of funds to buy back stock may seem an unwise use of resources to some investors now. The money, for instance, could have been used to reduce the amount of debt taken on for the acquisitions. The slight increase in AT&T's earnings per share that resulted as the buyback program shrunk the investor base may be of little comfort because the shares now are being hammered in no small measure because the company is so weighed down by debt.

An AT&T spokeswoman responds that no one could have foreseen the big decline in the long-distance phone business, which hurt the stocks of all long-distance telephone companies, or the declines in cable and wireless stocks. So criticism of the price it paid for its stock is equivalent to Monday-morning quarterbacking, she says. Moreover, AT&T says that it benefited by paying stock, in addition to debt, for much of its cable purchases, and it already planned to sell nonstrategic assets to pay down debt when it made the acquisitions in the first place.

Of course, buybacks work well for investors who sell their stock back to the company at high prices. But for those shareholders who didn't sell out, the reality is this: Companies sinking money into their own high-price stocks suffer an opportunity cost. The same money invested in plant and equipment could have generated a higher return and more earnings growth. In some cases, simply holding onto Treasury bills could provide a higher return than a buyback.

And while companies can make bad investment decisions building plants, or investing in a poor-performing stock other than their own, the decline in the value of the companies' own repurchased shares doesn't show up as a loss on the income statement. If a company's passive investment in another company plummets, the investing company must take a write-off.

Kent Simons, manager of $1.9 billion Neuberger Berman Focus Fund, says that when companies buy back their stock "all the time, it doesn't mean anything" in terms of a signal for others to buy those shares, too. But when companies seem to time buybacks for when their stocks are truly cheap, "those people I'll pay attention to." He cites Lattice Semiconductor, Compaq Computer and Cypress Semiconductor, which recently announced big buybacks.

At Cypress, "We do our buybacks when the stock is low and not high," says T.J. Rodgers, president and chief executive. "That's in the best interest of our shareholders."