Tuesday, June 05, 2007

Buyback Brouhaha

You cannot pick up a financial newspaper or click an investor web site these days without coming across an article or web log editorializing the stock buyback. That is because buybacks have become the dominant financial activity of the year. The March 2007 quarter shaped up as the third largest buyback period on record and its not over. S&P estimates $400 billion will be thrown at share purchases by U.S. public companies in 2007.

This has some meaning given that, along with private equity gobbling up another $600-plus billion in public companies shares, corporate buybacks will lead to a net reduction in public market capitalization. Public companies are spending more to purchase their own shares than they are on capital investments or dividends.

Some may argue that net share reductions are good for the company and the stock market in general. Shares outstanding are decreased. This is anti-dilutive, propping up price-earnings ratios and improving return on assets and equity measures. The counter argument is, of course, that the buyback is just a means to disguise poor performance and the failure of management to identify suitable investment opportunities.

Take note of
Wal Mart (WMT: NYSE), which is trying to secure a place in the record books as one of the largest buybacks in recent years with a pledge to spend $15 billion on share purchases. Wal Mart decided to scale back planned for supercenters in the U.S. so some might conclude management cannot find “suitable investment opportunities.” The case could be made that placing money in the hands of shareholders is the best investment Wal Mart can make, since arguably Wal Mart is making an investment in consumer purchasing power. How many supercenters does the world really need, anyway?

Of course, Wal Mart is unique, a behemoth with limited strategic or tactical options. Do corporate buybacks mean something different for scrappier small cap companies? The investment failure argument seems particularly apropos for the emerging company in the early stages of growth. Should not cash always be used strategically to achieve strategic goals? The answer must be no, because there is a phalanx of small companies announcing buybacks.

In the same week Wal Mart came out with its buyback announcement,
Callaway Golf (ELY: NYSE) and QLT, Inc. (QLTI: Nasdaq), the Canadian pharmaceutical company, revealed plans to take up shares.

Management of small companies frequently proclaim that the stock as undervalued and this is the best use of cash resources. ELY shares are trading at 22.5 times forward earnings. Callaway directors authorized $100 million to buy up to 5.5 million shares or 8% of its 72.1 million shares outstanding. If completed the buyback would result in a revised forward PE of 20.7 with no change in the consensus EPS estimate of $0.82 for 2007.

Since the sporting goods industry PE is around 25 times, there is hardly an egregious miscarriage of valuation in ELY. Yet Callaway management must see it that way as the Company only has $34.6 million in cash on its balance sheet and will need to borrow to complete the full authorization.

This brings us to another element in the buyback phenomenon, which we believe is particularly valuable for small companies. In the current interest rate environment borrowing costs are relatively low.

Furthermore, the buyback is an authorization but not commitment, giving small-cap management a great deal of flexibility. The buyback can be announced, the lubricating effects realized as shareholders digest the positive news, but management is under no obligation to proceed. This is quite different from a cash dividend, which, once started, is often looked upon as a barometer of financial health. Once declared the dividend must never be reduced. A buyback offers the opportunity to increase shareholder returns without the lifetime commitment.

This might be exactly what QLT directors had in mind in authorizing an extension of its buyback program by $50 million. The company already bought 13.4 million shares reducing shares outstanding by 15% to 75.4 million. Now the company is looking to take back in another 5.7 million shares. QLT is on the cusp of profitability and its program of in-licensing technology is a comparatively less costly approach to building its drug pipeline than internal development. Thus the $374.2 million in cash on its balance sheet at the end of December 2006, may be more of a burden than an asset. Since QLT does not have a dividend, a stock buyback is a good way to transfer the cash back to investors.

It seems to be quite easy to make the case for a buyback from the perspective of the corporation. Looking at these three companies it is difficult to imagine a case in which a buyback authorization would not be worthwhile, except maybe for those who do not already own shares.

Look for my next post on buybacks from the perspective of "non-shareholders" who are not recipients of corporate largesse.


Neither the author of the Small Cap Copy web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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