Share Repurchases: The Scary, Unintended Consequences

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Nomura Securities analyst Bill Carcache recently produced a report that studies share repurchases for many of the major banks dating all the way back to 1999. Interestingly for investors, Carcache found that some banks did much better than others.

share-repurchasesWells Fargo (WFC), for instance, did the best of any bank delivering an internal rate of return of 10.1%. WFCs share repurchases since 1999 cost the company $39.9 billion but today are worth $69.5 billion — great news for shareholders.

But there is an unintended consequence of these share repurchases. Care to guess what that is?

Share repurchases often (but not always) reduce a company’s overall share count, which in turn reduces the dollar amount of dividends paid out. In the case of Wells Fargo it saved paying out $9.1 billion in dividends as a result of its buyback program. Unfortunately, despite the $70 billion investment, WFC investors saw its share count between 2008 and 2014 increase by 58% thanks to several common stock offerings used to repay the US Treasury’s TARP investment in WFC.

So, not only did WFC shareholders receive $9.1 billion less in dividends as a result of these share repurchases, but they’ve also seen its share count increase dramatically which is exactly the opposite result they were looking for in the first place.

Carcache’s research has me wondering how much other S&P 500 companies save in terms of dividends paid out as a result of share repurchases. Selecting three companies from three different sectors of the S&P 500 Buyback Index, I’ll examine the unintended shareholder consequences over the past five years.

Unintended Consequences of Share Repurchases: Tyson Foods (TSN)

share-repurchasesTyson Foods (TSN) is in the midst of an M&A tug of war with Pilgrim’s Pride (PPC), its biggest meat processing rival, for Hillshire Brands (HSH). PPC currently is on top with an offer of $55 for the former Sara Lee spinoff. Some suggest that TSN should walk away from the bidding because things have already gotten out of hand. I can’t speak for Tyson or Pilgrim’s Pride, but you have to believe HSH shareholders are smiling ear-to-ear.

Tyson’s share repurchases between 2009 and 2013 totaled 54.9 million, costing the company $1.15 billion. From a dividend perspective, it would have saved approximately $68 million (20% of $341 million dividends paid) over the past five years by not paying out on those shares which represented 20% of the outstanding Class A stock.

At the June 6 closing price of $40.12, Tyson’s looking at an unrealized profit of $1.1 billion and a theoretical compound annual growth rate of 13.9% — 120 basis points higher than the SPDR S&P 500 (SPY). TSN shareholders have received a decent return on investment from these share repurchases along with the doubling of its annual dividend per share.

Ultimately, however, shareholders would have gotten a lower total dividend payout if the company hadn’t upped the dividend rate per share. Furthermore, the fact that the company felt it couldn’t reinvest the $1.1 billion in its business and deliver the same rate of return suggests its business has little room to grow — hence the Hillshire Brands offer.

Unintended Consequences of Share Repurchases: Lowe’s (LOW)

share-repurchasesBetween 2009 and 2013, Lowe’s (LOW) share repurchases totaled 490 million at an average price paid of $29 per share for a total cost of $14.2 billion. Based on its June 6 closing price of $47.77, its compound annual growth rate on its buybacks over the past five fiscal years is 10.5%, almost nine percentage points worse than the SPY. By simply investing in the index rather than LOW stock, it could have doubled its unrealized profit.

Interestingly, LOW stock paid out $733 million in dividends in 2013 — 71% higher than what it paid out in 2008. That seems like a good thing until you consider that if it hadn’t made any share repurchases over the past five years while paying out the same dividend payments per share, it would have spent an additional $910 million on dividends (based on a share count of 1.47 billion in fiscal 2008) while retaining the use of $14.2 billion to improve a business that hasn’t exactly been running on all cylinders.

Instead, it spent $14.2 billion over five years to generate an unrealized profit of $9.2 billion plus an additional $910 million in dividend savings. Thanks to the 33% reduction in share count, it was able to grow its earnings per share by 7.5% annually. Without the share repurchases, its earnings per share would have seen zero growth.

Clearly, the $14.2 billion could have been better spent.

Unintended Consequence of Share Repurchases: Yahoo (YHOO)

share-repurchasesAccording to Yahoo’s (YHOO) 2013 proxy, former COO Henrique De Castro’s severance was worth $58 million at the time of his dismissal in mid-January. Today, the share portion of De Castro’s severance is worth $63.2 million, less the $14 million exercise price of his 746,362 performance options, which expire August 4, 2014. Assuming De Castro exercises his options, the former executive is sitting on 1.76 million shares of YHOO stock in just 15 months of work.

It’s arguably Marissa Mayer’s worst call as CEO. But what does De Castro’s cushy severance have to do with the unintended consequences of share repurchases?

Lots.

Yahoo issues approximately $200 million of its stock on an annual basis as part of its compensation for named executive officers and other Yahoo employees. In order to minimize dilution it’s necessary to make share repurchases from time to time, regardless of price. However, over the past five fiscal years, Yahoo reduced its share count by 24% to 1.07 billion, which means management also bought its stock because it felt it was cheap.

If the $9 billion it spent between 2009 and 2013 to buy back YHOO stock was used for anything other than share repurchases, Yahoo management might have hung on to the 523 million Alibaba shares it sold in 2012. If they had, its investment in Alibaba could be worth as much as $62 billion today or 170% of Yahoo’s current market cap.

Jerry Yang was wise to make a $1 billion gamble in 2005 on Alibaba. Regardless of what you think of Yahoo’s co-founder, you have to acknowledge that this $1 billion investment has achieved far more over the years than the $9 billion in share repurchases it has made since 2009.

Imagine what might have been if Yahoo spent the $9 billion on nine different investments. Its future would likely be a lot brighter, making this another unfortunate consequence of share repurchases.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.


Article printed from InvestorPlace Media, https://investorplace.com/2014/06/share-repurchases-unintended-consequences/.

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