Patriot Scientific

Buybacks gain in popularity. Share buybacks are becoming more popular as a way to boost share price, restructure balance sheets, and return corporate cash to shareholders. In 1999, 1,253 NYSE-listed companies spent $181 billion purchasing their own shares, only $35 million less than they had distributed in dividends. Supporting the strategy’s popularity is the 2% to 12% increase in share price that many companies experience after a buyback. The notion that a buyback increases per-share earnings is a fallacy, since the cash spent to repurchase shares cancels out any effect on per-share earnings. However, it does affect value by signaling management’s optimism about the company’s prospects and by changing its capital structure. An excellent way to return cash to shareholders, buybacks for some companies have replaced dividend distributions, which are taxed at both the corporate and personal level.

Good vibrations, bad news. The announcement of a share buyback usually sends a positive message to the markets, yet occasionally other news overshadows and nullifies the favorable effects. From November 1998 through October 2000, Hewlett-Packard spent $8.2 billion to repurchase 128 million of its shares. Unfortunately, this positive signal was eclipsed by a series of adverse events, including a failed acquisition and weakening financial results, causing H-P’s share price to drop. Within months, it was down 50% from the average $64 price of repurchased shares. The effects of a buyback are not as positive for a technology company like Hewlett-Packard, which can usually use cash to better advantage in developing new products. When the buyback includes shares tendered by management, the message becomes a negative one.

Linked to leverage. Share buybacks affect value by changing the leverage on a company’s balance sheet. This often has a beneficial effect by increasing ROE, especially for an under-leveraged company. In 2000, Payless ShoeSource nearly trebled its long-term debt by repurchasing 25% of its shares. Although debt increased to 33% from 10%, share price rose 30%. Interest payments are a deductible expense, thus rendering the cost of the extra debt below the company’s cost of capital and the expected return on equity. Increasing debt to repurchase shares is a viable strategy only if a company has strong current and future cashflows, assuring shareholders that the debt can be repaid. Additional debt can also act as a discipline to management. Future cashflows earmarked to repay debt cannot be used for projects that would earn returns below a company’s cost of capital.

Buy, tender, or auction. Shares can be repurchased on the open market, through a fixed-price tender offer, or through a Dutch auction. Buying shares on the open market is the most common type of repurchase, but also the most expensive. It is the method least likely to signal that management believes company shares are overvalued. The SEC limits share purchases executed on the open market from time to time to 25% of average daily volume over the preceding four weeks. A fixed-price tender, generally used to repurchase more than 15% of a company’s shares, sends the most positive signal to the capital markets, by offering a substantial premium for shares. This is a method for financially strong companies that are secure in their financial outlook. The Dutch auction, where shares are repurchased for a median price in a preset range, is also used for large repurchase plans. With this method, the shareholders help to determine the buyback price and number of shares by responding to management’s tender offer with a greater or a smaller number of shares, depending upon the price range. This method is also the most equitable for the nontendering shareholders.

Size matters. The number of shares to be repurchased is a critical part of a buyback plan. Sizing depends primarily on the buyback’s purpose. If the goal is to alter the capital structure, then the company’s market value, share price, and optimum debt level determine the number of shares. If, on the other hand, the primary goal is to send a positive signal to the capital markets, managers must determine a materiality level, i.e., a number that measures the impact on the equity of shareholders who retain their shares. Shares that are "undervalued by the market will have a higher materiality level than shares that are fully valued. Generally, a buyback needs a minimum materiality level of 5% to cause any meaningful revaluation of share price.