Your company's buying back stock? Hurray! Or should that be "boo"?
According to research conducted by Boston University finance professor Allen Michel, when a company announces it's buying back stock, that stock tends to outperform the market by about 2% to 4% more than it otherwise would have over the ensuing six months.
But over the long term, multiple studies argue that buybacks destroy shareholder value. Famed CNBC pundit Jim Cramer cites the example of big banks like Bank of America, which bought back shares in 2007-2008 -- just before their stocks fell off a cliff. Cramer dismisses the concept of buybacks as buy signals, calling them "a false sign of health ... and often a waste of shareholders' money." And the Financial Times recently warned: "The implied returns over a period from buy-backs by big companies would have been laughed out of the boardroom if they had been proposed for investment in ... conventional projects."
So why do buybacks at all? According to FT, management can use them to goose per-share earnings, which helps CEOs earn bonuses based on "performance." Also, the investment banks that run buybacks for management get fees and other income from promoting buybacks. But you and me? We miss out on gains unless those purchases cost less than the actual intrinsic value of the shares.
And we're about to miss out again.
Two bad buybacks
StreetInsider.com keeps a running tally of which companies are buying back stock and how much they're spending. SI is too polite to accuse companies of actually wasting shareholders' money, of course -- but I'm not. With SI's help, I've come up with two examples of popular stocks that I believe are squandering shareholder dollars on badly timed buybacks -- one of which could spend its cash a lot smarter.
Hansen Natural (NAS: HANS) The first catcall this week goes out to Hansen Natural. This month, the maker of Monster energy drinks announced that it had drained the last drop from its last $200 million repurchase authorization -- and was going back for more. The company now wants to spend $250 million more of your money buying back its own stock.
"And why not?" you ask. The last round of buybacks, announced when the stock was trading for $40 and change, worked out pretty well for Hansen. The stock has doubled since then.
Problem is that after doubling, Hansen's share price looks pretty frothy. With a P/E ratio more than twice that of market behemoth Coca-Cola (NYS: KO) , Hansen shares now cost 31 times earnings, despite having a projected growth rate just half that. Hansen's P/E now exceeds that of SodaStream International (NAS: SODA) , another high-flying pop purveyor that recently lost its fizz. And don't even get me started on the free cash flow situation -- if Hansen looks overpriced on a PEG basis, it's downright expensive when valued on free cash flow, which lags reported "earnings" by more than 20%.
International Business Machines (NYS: IBM)
Investors were feeling "blue" last week when IBM shares lost 7% of their market cap over just a few days' trading. In outgoing CEO Sam Palmisano's words, IBM "drove revenue growth, margin expansion, and increased earnings" in the third quarter, but none of the numbers were quite as big as investors had hoped. Hoping to buck up the share price, IBM quickly authorized an additional share repurchase of $7 billion, which, when combined with the leftovers of its last buyback plan, empowers management to buy back as much as $12.2 billion worth of shares in total. But is that really the best use of the cash?
I mean, I'm a fan of IBM. You know that already. But I do have concerns about the stock price. IBM shares cost nearly 15 times earnings. Between the stock's 1.6% dividend yield and its 12% long-term growth rate (nearly a third faster than the average stock on the Dow Jones Industrial Average (INDEX: ^DJI) achieves), I think the share price is fair.
A better use of cash
Problem is, I'm not looking for fair. I'm looking for cheap -- and I don't think IBM shares are sufficiently cheap to justify spending 5% of the company's market cap on buybacks. If you ask me, a quality operator like IBM could better serve its shareholders by spending this cash to buy a complementary business -- something like Nuance (NAS: NUAN) , for example, whose speech-recognition technology would slot in quite nicely with IBM's Watson artificial intelligence project. With Nuance selling for just $8 billion and change, IBM could swallow it and not even burp.
And another thing: Right now, Nuance is a company with a great product -- but poor management and lousy profit margins. But what if IBM were able to transfer its 15% net margin to Nuance's revenue stream? This would result in an immediate quadrupling in the latter's annual profit -- a pretty quick return on investment.
Foolish final thought
Take the growth potential from Nuance's role in the new Apple (NAS: AAPL) iPhone 4S, turbocharge it with the brains behind Watson, and what do you get? I think you get a Siri that's more than just a pleasant personality. I think you get a voice-operated, mobile supercomputer in every American's pocket -- and a nice profit in every IBM shareholder's portfolio.
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At the time thisarticle was published Fool contributorRich Smithdoes not own (or short) shares of any company named above. The Motley Fool owns shares of IBM, Apple, and Coca-Cola.Motley Fool newsletter serviceshave recommended buying shares of Coca-Cola, SodaStream, Hansen Natural, Nuance Communications, and Apple; as well as creating a bull call spread position in Apple. Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy.
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