Executives

From Ibmer

Revision as of 07:02, 8 May 2007

Questioning the strategy of Share Buybacks

There's a (small) tax incentive.

IBM was one of the first firms to re-purchase its stock in 1974—the company had found itself with more cash than it needed¹.

But should a firm return this excess cash to shareholders via a share re-purchase or via dividends? The distinction between re-purchase and dividends lies in the tax treatment:

• Shareholders who sell shares back to the firm pay tax only on capital gains realized in the sale.
• Dividends are taxed as ordinary income.

But by 2005 McKinsey admitted that the tax advantage of share buybacks was 'small'².

Buybacks send the signal that the firm has excess cash and few (if any) investment ideas.

An article in The McKinsey Quarterly 2005 Number 3 spells out the pros and cons of re-purchasing shares:

'... buybacks an alluring substitute if improvements in operational performance are elusive ... Investors are generally relieved to learn that companies don't intend to do something wasteful—such as make an unwise acquisition or a poor capital expenditure—with the excess cash ... A second positive signal is management's confidence that the company doesn't need the cash to cover future commitments such as interest payments and capital expenditures ... But there is a third, negative, signal with a buyback: that the management team sees few investment opportunities ahead, suggesting to investors that they could do better by putting their money elsewhere ...'

'... by allowing management compensation to be linked to EPS, boards run the risk of promoting the short-term effects of buybacks instead of managing the long-term health of the company. Similarly, value-minded executives in industries where good investment opportunities are still available must resist the pressure to buy back shares in order to reach EPS targets.'

'Only when boards and executives understand the difference between fundamental value creation through improved performance and the purely mechanical effects of a buyback program on EPS will they put share repurchases to work creating value.'

But IBM doesn't have enough excess cash.

But IBM's recent announcements (e.g. April 24, 2007 at Bloomberg) shows that IBM's strategy people are so enamoured with share buybacks that the company will borrow money to finance the buyback:

'... IBM plans to take on debt to finance much of the buyback and probably won't be able to sustain this repurchase level in the future, Treasurer Jesse Greene said today in an interview.'

So in IBM's case, there isn't the excess cash for investors to be concerned about.

Sources:

• 1. Principles of Corporate Finance. Brealey and Myers (McGraw-Hill 1984)
• 2. The McKinsey Quarterly 2005 Number 3. Dobbs and Rehm (2005)