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PC companies moved today as investors attempt to price in incremental information in advance of the second quarter earnings season. Word from distributors is that inventory is nearing targeted levels, as computer distributor CHS Electronics <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CHSE)") else Response.Write("(Nasdaq: CHSE)") end if %> reportedly has three weeks of Compaq <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPQ)") else Response.Write("(NYSE: CPQ)") end if %> PCs in inventory and five weeks of IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> machines. Value-added resellers MicroAge <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MICA)") else Response.Write("(Nasdaq: MICA)") end if %>, Vanstar <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VST)") else Response.Write("(NYSE: VST)") end if %>, and Pomeroy Computer <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PMRY)") else Response.Write("(Nasdaq: PMRY)") end if %> reportedly have 4-6 weeks of inventory among them. With heavy contra revenues (credits for future sales discounted against current revenues) having already flowed through the income statement of Compaq last quarter and expected to flow through this quarter, investors are looking ahead to a more constructive sales environment for PC makers. Compaq gained $1 3/4 to $31 9/16 today following yesterday's Morgan Stanley reiteration of a "strong buy" on Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>. Earlier today, most of the PC makers showed strength, but only Dell <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %> carried through with a $3 1/2 gain to $99 7/8, as its inventory turnover and rich product mix among desktops, laptops, servers, and workstations should gird its margins against average selling price erosion. Gateway <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GTW)") else Response.Write("(NYSE: GTW)") end if %> finished the day up $2 1/8 to $61 7/8 after denying takeover rumors, some of which featured IBM as the suspected suitor.
Hambrecht & Quist <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HQ)") else Response.Write("(NYSE: HQ)") end if %> gained $1 1/2 to $37 7/16 as Germany's largest bank, Deutsche Bank AG, is reportedly considering acquiring a U.S. investment bank in the wake of the departure of Frank Quattrone and part of his gang from DMG Technology Group. Having been the lead underwriter for such clients as Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %>, DMG's West Coast presence has been diminished with the departure of Quattrone, and some people think that Deutsche Bank is considering getting back into the game with H&Q as its substitute striker.
QUICK TAKES: Pfizer <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PFE)") else Response.Write("(NYSE: PFE)") end if %> gained $2 1/2 to $116 in advance of reporting Q2 EPS of $0.47 a share, up from $0.35 in the year-ago period and beating analysts' mean estimate of $0.45. The drug maker said its hot-selling impotence drug Viagra brought in $411 million in sales during the quarter... General Electric <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GE)") else Response.Write("(NYSE: GE)") end if %> brought good things to shareholders' lives today by gaining $13/16 to $94 1/8 after reporting Q2 earnings of $2.45 billion, or $0.74 a share, up from last year's $0.65 and meeting analysts' mean estimate... Walt Disney Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DIS)") else Response.Write("(NYSE: DIS)") end if %> rose $2 11/16 to $111 1/4 after Morgan Stanley Dean Witter reiterated a "strong buy" on the entertainment giant with a $135 price target. Yesterday, Tina Brown quit the top post at The New Yorker magazine to head a new unit of Disney's Miramax Films that will create a monthly magazine, produce movies and TV shows, and publish a line of books.
American Eagle Outfitters <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AEOS)") else Response.Write("(Nasdaq: AEOS)") end if %> rose $3 3/4 to $46 7/8 after the casual apparel retailer announced that comparable-store June sales were up 26.4% from the year-ago period... Similarly, women's apparel retailer AnnTaylor Stores <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ANN)") else Response.Write("(NYSE: ANN)") end if %> sewed on $1 3/4 to $23 1/16 after announcing a 9% increase in June same-store sales... Music, software, and CD-ROM distributor Navarre Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NAVR)") else Response.Write("(Nasdaq: NAVR)") end if %> shot up $3 to $7 3/16 after announcing it has become a strategic supplier of consumer software to barnesandnoble.com. Barnes & Noble <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BKS)") else Response.Write("(NYSE: BKS)") end if %> added $1 1/16 to $44 3/16... Federal Express parent FDX Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FDX)") else Response.Write("(NYSE: FDX)") end if %> took off for a $4 15/16 gain to $66 1/16 after delivering Q4 EPS of $1.14 (before charges) compared with $0.91 last year.
Waste management services company USA Waste Services <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UW)") else Response.Write("(NYSE: UW)") end if %> picked up $1 5/16 to $52 15/16 and proposed merger partner Waste Management <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMX)") else Response.Write("(NYSE: WMX)") end if %> gained $1 3/16 to $37 7/8 after Standard & Poor's raised its ratings on the companies and removed them from CreditWatch... Healthcare management company WellPoint Health Networks <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WLP)") else Response.Write("(NYSE: WLP)") end if %> rose $1 7/16 to $71 1/16 on news it will buy Cerulean Companies, the parent of Blue Cross & Blue Shield of Georgia, for around $500 million. WellPoint also announced plans to buy back an additional 8 million shares... Diversified industrial equipment and components manufacturer Ingersoll-Rand Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IR)") else Response.Write("(NYSE: IR)") end if %> gained $1 1/4 to $42 7/16 after pre-announcing Q2 EPS of $0.85, up from last year's $0.68.
Fred Meyer Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FMY)") else Response.Write("(NYSE: FMY)") end if %> rose $2 to $48 1/2 after Standard & Poor's announced that the company will replace Echlin Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ECH)") else Response.Write("(NYSE: ECH)") end if %> in the S&P 500 Index after the bell today. Echlin is being acquired by Dana Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DCN)") else Response.Write("(NYSE: DCN)") end if %>... Rehabilitation and employee services provider NovaCare Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NOV)") else Response.Write("(NYSE: NOV)") end if %> added $1 3/8 to $12 5/8 after announcing it has hired Salomon Smith Barney and Wasserstein Perella & Co. to "explore strategic alternatives, including a spin-off of one or more of its businesses"... Biotechnology company Cerus Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CERS)") else Response.Write("(Nasdaq: CERS)") end if %> jumped $1 9/16 to $17 1/2 after announcing that Baxter Healthcare, a unit of Baxter International <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAX)") else Response.Write("(NYSE: BAX)") end if %>, will buy up to $14.5 million of Cerus preferred stock. In addition, Baxter will provide a minimum of $60 million over the next several years to fund cooperative development of pathogen inactivation systems for platelets and red blood cells used for transfusion.
Vitesse Semiconductor <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VTSS)") else Response.Write("(Nasdaq: VTSS)") end if %>, which makes high bandwidth communications and automatic test equipment integrated circuits, added $1 11/16 to $34 11/16 after reporting fiscal Q3 EPS of $0.18 compared with $0.12 in the prior-year period... Stent and balloon angioplasty systems company Arterial Vascular Engineering <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AVEI)") else Response.Write("(Nasdaq: AVEI)") end if %> gained $3 1/4 to $42 after announcing it will acquire the coronary catheter lab business of C.R. Bard <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BCR)") else Response.Write("(NYSE: BCR)") end if %> plus rights to the supply by Bard of certain materials for around $550 million in cash... Refractive laser technology company VISX Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VISX)") else Response.Write("(Nasdaq: VISX)") end if %> jumped $4 15/16 to $66 5/8 after announcing it had reached a settlement with the FTC and entered into a consent decree regarding the formation and operation of Pillar Point Partners, which it voluntarily dissolved on June 8. All of VISX's patents previously licensed to the partnership have been returned to the company.
PC and computer products direct marketer PC Connection <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PCCC)") else Response.Write("(Nasdaq: PCCC)") end if %> advanced another $1 1/4 to $19 1/4 in the wake of reporting a 43.5% year-over-year increase in net sales in fiscal Q2 to $174.3 million... American Materials & Technologies <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMTK)") else Response.Write("(Nasdaq: AMTK)") end if %> surged $1 29/32 to $4 29/32 after announcing it has agreed to be acquired by Cytec Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CYT)") else Response.Write("(NYSE: CYT)") end if %> in an all-stock transaction that values American Materials at $6 per share -- double its price at yesterday's close... Fish processor and Internet company Zapata Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ZAP)") else Response.Write("(NYSE: ZAP)") end if %> rose $7/8 to $17 1/4 after announcing that its Internet subsidiary, ZAP Corp., will acquire Advancing Women, a bilingual website for women, for an undisclosed sum.
Retailer J.C. Penney Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JCP)") else Response.Write("(NYSE: JCP)") end if %> slid $5 13/16 to $65 5/8 after reporting a 2.1% decline in June same-store sales compared to the same month a year ago. Moreover, the company said its fiscal Q2 earnings will come in below the $0.38 per share earned last year, missing the Street estimate of $0.49 per share. In a conference call today, the company indicated that its July comp numbers won't be much better than June's, with growth somewhere in the low single-digit neighborhood. Popular summer-related merchandise moved well in early June, but the demand sapped Penney's inventory of hot items and left it with a glut of slow-moving stuff such as sneakers and men's clothing to peddle during the following weeks. The company tried to spur sales by slashing prices, but the markdowns didn't lure enough buyers to Penney's stores to offset the damage they did to the retailer's margins.
It was a bad day to be a drug wholesaler as a federal judge intimated yesterday that he may not throw his judicial weight behind two proposed mergers in the sector. AmeriSource Health Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AAS)") else Response.Write("(NYSE: AAS)") end if %> lost $5 15/16 to $66 1/6 and McKesson Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MCK)") else Response.Write("(NYSE: MCK)") end if %>, with which AmeriSource has a deal, fell $1 3/16 to $88. Bergen Brunswig Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BBC)") else Response.Write("(NYSE: BBC)") end if %> slid $3 15/16 to $47 15/16 and partner-to-be Cardinal Health <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CAH)") else Response.Write("(NYSE: CAH)") end if %> dropped $2 3/8 to $98 5/8. The FTC is looking for a preliminary injunction from the courts to stop the proposed hook-ups on the grounds that diminishing competition could lead to higher prices and less service. Yesterday, Judge Stanley Sporkin suggested the deals might hurt smaller wholesalers, since he feels that "the business nationwide is already allocated." A decision is expected by the end of the month. If Sporkin grants the injunction, the proceedings will move to an FTC administrative law judge -- at which point McKesson and Cardinal may find it easier to just call off the whole shootin' match.
Shares of Yahoo! <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: YHOO)") else Response.Write("(Nasdaq: YHOO)") end if %> traded as high as $204 today but finished down $2 3/16 to $184 after reporting higher-than-expected second quarter EPS of $0.15, excluding charges, up from a $0.01 loss in the year-earlier quarter. That beat the $0.09 consensus estimate as well as the supposed "whisper number" of $0.12. Also boosting Yahoo's initial rise today was its announcement of a 2-for-1 stock split, which will be reflected in its trading price Aug. 3. More significantly, Yahoo! said it has finalized a private sale of 1.36 million shares to Softbank Holdings, the U.S. subsidiary of Japan's Softbank Corp., which will now own 31% of Yahoo!'s stock. The transaction was set at a market price of $183 and so will add $250 million to the Internet leader's $147 million cash hoard for new partnerships and acquisitions. Yahoo! also reported that average page views per day increased to 115 million in June, up 21% from March. The number of registered users grew to 18 million from 12 million in March. Some of the usual (Internet) suspects also moved up on the back of Yahoo!'s earnings report: America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> climbed $3 1/8 to $113 7/8, NetGravity <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NETG)") else Response.Write("(Nasdaq: NETG)") end if %> advanced $2 7/8 to $24 7/8, and Egghead.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: EGGS)") else Response.Write("(Nasdaq: EGGS)") end if %> moved up $1 3/4 to $17.
QUICK CUTS: Advanced Micro Devices <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AMD)") else Response.Write("(NYSE: AMD)") end if %> fell $2 1/4 to $15 7/8 after reporting a fiscal Q2 loss of $0.45 per share compared to earnings of $0.07 per share a year ago. The Street had been expecting a loss of $0.20 per share... Chemicals and life sciences company DuPont <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DD)") else Response.Write("(NYSE: DD)") end if %> dropped $7 to $70 1/8 after saying its fiscal Q2 earnings will come in 10% to 15% below the $0.99 per share earned a year ago, missing the Street estimate of $1.01 per share... Retailer Kmart Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KM)") else Response.Write("(NYSE: KM)") end if %> fell $1 1/16 to $18 5/8 after reporting a 1.5% rise in same-store sales in June compared to the same month a year ago. However, the company said the results were "below plan" due to adverse weather and soft Father's Day sales.
Retailer Nordstrom <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NOBE)") else Response.Write("(Nasdaq: NOBE)") end if %> fell $1 3/4 to $37 1/2 on a NationsBanc Montgomery Securities downgrade to "hold" from "buy"... Case Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CSE)") else Response.Write("(NYSE: CSE)") end if %> slid $2 9/16 to $44 3/4 after J.P. Morgan downgraded the farm and construction equipment maker to "market perform" from "buy"... Anti-impotency products maker Vivus Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VVUS)") else Response.Write("(Nasdaq: VVUS)") end if %> lost $1 15/32 to $7 23/32 after announcing it is looking for "a major pharmaceutical partner" to market its Muse treatment in the U.S. in response to strong competition from Pfizer's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PFE)") else Response.Write("(NYSE: PFE)") end if %> Viagra drug... Case Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CSE)") else Response.Write("(NYSE: CSE)") end if %> slid $2 9/16 to $44 3/4 after J.P. Morgan downgraded the farm and construction equipment maker to "market perform" from "buy."
Pharmaceutical company Alza Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AZA)") else Response.Write("(NYSE: AZA)") end if %> fell $2 7/8 to $41 7/8 after saying it will more than triple its U.S. sales force to 360 from 100 in order to increase the exposure of its urology and oncology products to physicians. The move will result in a "modest dilution" of the firm's fiscal 1998 EPS, which the Street had expected to come in at $1.42... Medical device maker Cardima Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CRDM)") else Response.Write("(Nasdaq: CRDM)") end if %> gave back $2 25/32 to $6 3/16 after more than tripling yesterday on news that the FDA had approved its Vueport guiding catheter for viewing the coronary venous system... Photronics Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PLAB)") else Response.Write("(Nasdaq: PLAB)") end if %>, which makes photomasks used in the production of semiconductors, slipped $4 3/16 to $17 11/16 after saying fiscal Q3 EPS could be 25% to 35% below the First Call mean estimate of $0.33.
Boating products retailer West Marine <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WMAR)") else Response.Write("(Nasdaq: WMAR)") end if %> sank $4 5/16 to $12 1/4 after saying it expects its fiscal Q2 EPS to come in between $0.47 and $0.52, falling short of the IBES mean estimate of $0.73 for the period. The company also announced that CEO Crawford Cole quit... Powerwave Technologies <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PWAV)") else Response.Write("(Nasdaq: PWAV)") end if %>, which makes power amplifiers for the wireless communications market, slid $2 9/16 to $15 15/16 after reporting fiscal Q2 EPS of $0.11, which was in line with the First Call mean estimate. The company said some South Korean customers postponed, rescheduled, and cancelled orders during the period... Printed circuit board (PCB) and backplane assemblies maker Hadco Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: HDCO)") else Response.Write("(Nasdaq: HDCO)") end if %> dropped $3/8 to $21 3/4 after saying it expects a fiscal Q3 loss of between $0.45 and $0.50 per share due to the general electronics industry slowdown, customer product and inventory adjustments, and the Asian financial crisis. The Street had been expecting earnings of $0.10 per share in the period.
Lehman Brothers lowered its rating on three paper products companies to "neutral" from "outperform," sending their shares downward. Champion International <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CHA)") else Response.Write("(NYSE: CHA)") end if %> fell $1 5/8 to $47, Georgia-Pacific Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GP)") else Response.Write("(NYSE: GP)") end if %> lost $2 5/16 to $56 7/8, and Willamette Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WLL)") else Response.Write("(NYSE: WLL)") end if %> dropped $1 3/4 to $29 1/2... Long-distance phone service reseller CTC Communications Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CPTL)") else Response.Write("(Nasdaq: CPTL)") end if %> was knocked down $1 1/4 to $6 13/16 today. The sole analyst at a regional brokerage covering the company lowered his rating to "sell" from "hold" after CTC canceled a scheduled $125 million junk bond deal, which was to be used to fund a restructuring.
FOOL
ON THE HILL
An Investment Opinion
by
Dale Wettlaufer
Why Share Buybacks Matter
[Ed. Note: Today we present another "Fool on the Hill" encore. This material originally appeared in two parts on Mar. 27 and Mar. 31, 1998.]
Beginning investors can understand the reason why share buybacks are beneficial to them. The reasoning that their proportional share in the company is increased by share buybacks is logical. However, the many other benefits of share buybacks go beyond this logic.
A share buyback can be a very good indicator that management has its priorities in place. If a company cannot generate a return on investment on new projects that shareholders could receive from a buyback of shares, then the choice between new investments and the buyback would seem to be pretty clear. However, the benefits of a share buyback depend upon the situation at hand -- the company's growth opportunities and its cost of capital and sources of funding, among other things.
The pressures to allocate capital in sub-optimal ways are numerous, from a needy ego in the Chairman's office to simply bad judgment on the part of the people making the strategic calls. The rational board of directors and management team will look at the above factors and will choose, hopefully, the course of action that will create the most shareholder value.
Start with a company with $1 billion in financial capital ($1 billion in shareholders' equity). In the baseline year, the company earned a 15% return on beginning capital, or $150 million after tax, and ended the year with a $3 billion market cap and 100 million shares outstanding at $30 per share.
Now, say the board of directors hears from the company's management that they cannot find any new investment possibilities that can earn more than a 12% return on capital. Furthermore, marginal investments above the first billion dollars in the core business will not generate returns above 12%. Assume that depreciation equals capital expenditures and all earnings are retained. Growth is financed solely from retained earnings and return on capital is figured in this case as return on beginning of year capital. (AOL users, expand window to view table)
EPS P/E Yr.-End Capital Share Price Shareholder Ret.
Base: $1.50 20 $1.15 billion $30
Year 1: 1.68 20 1.318 33.60 12%
Year 2: 1.88 20 1.506 37.63 12
Year 3: 2.11 20 1.717 42.14 12
Year 4: 2.36 20 1.953 47.20 12
This could go on ad infinitum, but the relationship is pretty clear. If the return on marginal capital is 12%, then shareholder return going forward will match the return on marginal capital assuming no change in P/E. Should investors fear that new investment opportunities are limited or fear that the fat 15% returns on capital devoted to the core business are in jeopardy, then the P/E multiple could contract, jeopardizing shareholder return.
For the management that is not satisfied with new investment opportunities that barely meet their cost of capital and decides instead to return all earnings to shareholders via yearly share buybacks, the total capital of the company would not change over five years (so we'll leave that column out), but EPS and shareholder return will vary. The market cap won't change unless there is a change in attitude toward the prospects of the company, as in the former example. The company buys back the shares at that year's average market price:
EPS P/E Shares Out. Share Price Shareholder Return
Base: $1.50 20 100 million $30
Year 1: 1.58 20 95 31.58 5.3%
Year 2: 1.66 20 90.25 33.24 5.3
Year 3: 1.75 20 85.74 34.99 5.3
Year 4: 1.84 20 81.45 36.83 5.3
Ad infinitum. The company has chosen a sub-optimal course of action. The first plan at least resulted in projects that met their cost of capital and created far more value for shareholders over the five-year period. Even without barn-burning growth opportunities, the first course of action was more desirable. Share buybacks might be the zeitgeist and might show up statistically as a stimulant to shareholder value, but that's because there are more than these two ways to increase shareholder value through buybacks.
In these two examples we see that in cases where a company's after-tax return on capital was greater than its cost of capital, then shareholder value can be destroyed if a company blindly chooses share buybacks over new investments. The cost of share buybacks is a function of opportunity cost of capital (or the opportunities foregone in choosing another investment), the price at which the share buyback can be accomplished, and the cost of capital funding the buybacks, among other things.
The base case assumption is the same for all examples. The company starts with capital of $1 billion, earnings of $150 million, shares outstanding of 100 million, a growth rate in capital employed of approximately 15% per year, an after-tax return of 15% on the first $1 billion in capital, and a 12% after-tax return on all capital past $1 billion. The cost of debt in all examples is 7% and the tax rate is 35%. Also, where debt is part of the equation, we look at the enterprise value-to-earnings ratio rather than just the standard price-to-earnings (P/E) ratio. Where there is no debt, there is no difference between the enterprise value-to-earnings ratio and the P/E ratio because there is no cash on the balance sheet in any example. (Most figures have had digits to the right of the decimal truncated for ease of presentation. AOL users should expand window to view tables).
In the first example below, the company plows back all earnings into its capital expenditures. The difference between capital investment that it requires and the prior year's earnings, it makes up via the issuance of debt.
Capital Erns. Debt EV Share Pr. Shrhlder Ret.
Base $1,000 $150 $0 $3,000 $30.00
1 1,150 168 0 3,360 33.60 12.00%
2 1,321 188 3.68 3,768 37.65 12.05
3 1,518 211 11.73 4,232 42.21 12.12
4 1,743 238 24.96 4,760 47.36 12.19
5 2,000 268 44.3 5,360 53.16 12.26
By the end of five years, the company has increased capital in use by $1.0004 billion and has only issued debt of $44.3 million. The company's debt-to-equity ratio, then, at the end of year 5 is less than 3% (debt of $44.3 divided by the total capital of $2,000.4 minus debt of $44.3).
Yearly shareholder return is nearly equal to the return on marginal capital employed by the company. Since a small amount of debt is being used, part of the company's income is sheltered from income taxes as interest expense is tax-deductible. The smaller effective tax rate accounts for an increase in shareholder return past the 12% return on marginal capital being plowed into the business.
In the next example, the company increased capital at the same rate as above, but sends back all earnings to shareholders via share buybacks, financing capital growth exclusively with debt. Share buybacks for year 1 are done with the earnings from the prior year and are accomplished as close as possible to the beginning of year 1.
Capital Erns. Debt Shares EV/E EV Share Pr. Shrhlder Ret.
Base $1,000 $150 ---- 100 20 $3,000 $30 ----
Yr. 1 1,150 161 $150 95 20 3,223 32.35 7.8%
Yr. 2 1,321 173 321 90 20 3,478 35.07 8.4
Yr. 3 1,518 224 518 85 20 3,771 38.28 9.2
Yr. 4 1,743 188 743 80 20 4,107 42.05 9.8
Yr. 5 2,000 224 1,000 75 20 4,490 46.53 10.6
Having been bought back at an enterprise value-to-earnings ratio of 20 each year, shares outstanding have fallen by approximately 5 million per year, such that we've killed off 25 million shares by the end of year 5. Of course, what we end up with is a highly leveraged company with a debt-to-equity ratio of 1-to-1. Nevertheless, our debt service coverage of 5.9 times earnings before interest and taxes (EBIT) to interest expense is fine.
The net result of using debt is that shareholder return has fallen short of the unleveraged example. Our pre-tax return to shareholders has beaten the pre-tax cost of capital (the 7% interest rate on the debt used), but we were better off financing our capital expansion with equity. At the end of year 5, we have just about $6.75 more value per share with far less debt in the first example than we do in the second example.
Lest you think this is a jeremiad on debt, it's not. It's really an illustration of the price at which companies buy back equity. Quite often, you'll hear about a huge share buyback authorization from a company whose stock has fallen apart. That's a one-day press release phenomenon for those companies that don't follow through on their authorization. A share buyback offers value for shareholders if the company can buy the shares beneath intrinsic value or the cost of equity capital.
In the following example, shares are bought back at 8.33 times enterprise value-to-earnings. That, not by coincidence, is the inverse of a pretty standard cost of equity capital of 12% (which is a percentage point higher than the long-term rate of return on the S&P 500).
Capital Erns. Debt Shares EV Share Pr. Shrhlder Ret.
Base $1,000 $150 $0 100 $3,000 $12.45
1 1,150 161 150 87 1,341 13.56 8.9%
2 1,322 173 321 75 1,441 14.91 10.5
3 1,518 188 518 63 1,556 16.48 10.5
4 1,743 205 743 51 1,707 18.90 14.7
5 2,000 224 1,000 40 1,865 21.62 14.4
Again, we have a case of the company's after-tax return beating its cost of capital, with the margin between return on capital and cost of capital increasing as a larger part of the company's capital base is represented by lower-cost debt. In all cases, though, the best way to increase shareholder return is to buy back shares when the cost of those shares is below the opportunities for marginal return on capital. The above cost of capital is just below the return offered by the company's investment opportunities, but over five years the return to shareholders is 11.7%. The return to shareholders just meets the return on marginal capital. It matters little whether expansion or share buybacks are financed with debt or equity -- in the end, the shareholder return will be at or below the marginal return on capital when the cost of buying back equity is at or above the cost of that equity.
The optimum course of action for the company would be to maintain the investment in its base business, which returns 15% on the first $1 billion in capital in use. Assuming the P/E stays constant at 8.33 and all earnings are used to buy back shares, the best shareholder return of all the possibilities results from a zero-growth business that can buy back shares at or below the cost of equity capital.
Shares Share Pr. Shareholder Return
Base 100 $12.50 ---
Yr. 1 87.99 14.20 13.64%
Yr. 2 77.43 16.14 13.64
Yr. 3 68.13 18.34 13.64
Yr. 4 59.96 20.84 13.64
Yr. 5 52.76 23.68 13.64
Capital -- How much (financial) capital the company employed during the year
Erns. -- Earnings
Debt -- Debt in use during year
Shares -- Shares outstanding as of year end
EV/E -- Enterprise Value-to-earnings ratio
EV -- Enterprise Value
Share Pr. -- Share price as of year-end
Shrhlder Ret. -- Shareholder return
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Contributing Writers Yi-Hsin Chang (TMF Puck), a Fool Brian Graney (TMF Panic), Fool Two Alex Schay (TMF Nexus6), Fool, too Dale Wettlaufer (TMF Ralegh), Final Fool
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