Explained: Debt-financed Share Buybacks

If you are reading this, you probably came across a financial news anchor complaining about share buybacks at some point in time or some financial expert on CNBC having a rant at debt-financed share buybacks (also known as share repurchases).

Share buybacks are very popular these days. Apple recently announced a $50 billion 10-year share buyback program.

What’s a Share Buyback

A share buyback is when a company uses cash to purchase some of its own shares. When a company issues shares and investors buy them, cash is flowing from the investor to the company. The company gets cash and the investor claims ownership of the company. A share buyback is basically a reversal of this process. The company takes cash and pays it back to the investor so that the investor does not own the company anymore. Of course, the company will never buyback all its shares. It is illegal and illogical to do so because that would mean that no one owns that business which defeats the classical goal of the firm.

What happens to the shares that the company buys back? The shares remain on the balance sheet of the company as Treasury stock which is essentially a contra to equity account. They reduce the total shareholders equity. These shares are not included in dividend calculations. The easiest way to conceptualize this is to think of it as an asset; the company bought a paper asset (Dr Asset Cr Bank)

There are basically four methods a company can employ in executing a share buyback. The most common is buying in the open market, just like how anybody else would do it. This is usually the best way to do it. Other methods are a Fixed Price Tender Offer, a Dutch Auction, and a Repurchase by Negotiation.

Why would a company do that?

• The basic motive is to improve financial metrics, especially Earnings per Share (EPS), which is key determinant of the share price. Simply put, when a company buys back shares, the total number of outstanding shares in investor’s hands decreases. Fewer people now claim ownership of the company. The actual earnings of the company have not changed, it’s only the bank account balance that has changed. The share price of the company should therefore increase bearing in mind that valuations are generally forward-looking. Most executive compensation packages and bonuses are tied to share price performance.
• To distribute cash to shareholders — instead of paying out a dividend, a company might opt for a share buyback. In both cases, shareholders are getting cash in their hands. Distributing cash to shareholders is a very noble endeavor especially when there are no profitable ventures that the company can invest the cash in. Instead of perpetually pursuing elusive growth and burning cash in negative NPV projects, the company does the honorable thing; return cash to shareholders.
• To respond to an undervaluation (real or perceived)- the management of a company might be of an opinion that the shares are trading at a very low level than warranted by fundamentals. Let’s say the market is valuing the share at $50 whilst the executive management are of the opinion that it should be above $80. If the company has enough free cash flow , it can go into the market and buy back some of its shares which forces the price per share to go up, though it does not change the total market capitalization. However, with time, the market’s opinion might change as the market’s knowledge about the company catches-up with the knowledge that management had at the time of the buyback. The company can then re-issue those shares at a higher price and get the cash they had laid out in the initial buyback. It’s simply raising more capital from each share.
• To generate value from changing the company’s capital structure- Issuing debt means more interest to be paid which reduces taxable profits and ultimately taxes to be paid. This is tax efficiency. With respect to corporate taxes, interest payments are superior to dividends. Changing the capital structure towards more leverage captures considerable value especially for highly profitable cash rich companies. Being highly profitable is good but it allows too much value to be captured by the government in the form of corporate taxes. Having excess cash on the balance sheet is good but it also means the interest income on that cash will be large as well as the tax. As of March 2020, Apple had close to $90 billion in cash reserves. The interest income on that cash balance could be above a billion if it is invested at just above 1% . The taxman walks away with 21% of that billion. Instead of keeping all of this cash on the balance sheet, it makes sense to just give it back to shareholders and avoid interest income and unnecessary taxes.

Is this really necessary in the 1st Place?

Share buybacks are controversial. There is a huge sentiment that buybacks do not generate value at all. There is a growing crowd of conspiracy theorists who believe that buybacks are just ways management tries to screw things up for investors, especially when they are financed by debt.

The base naysayers’ argument is that companies can only generate real value from actual operations. Real value is not generated from capital market stratagems and cosmetic capital structure changes.

Why would a company finance share buybacks using debt?

Sometimes a company wants to buy back its shares but does not have enough cash on the balance sheet. To raise funds,the company issues debt. This is essentially borrowing money and using the money to buy back your own shares. The entire transaction is a Debt-Financed Share Buyback. This is where it gets very controversial.

There is a huge camp that is against share buybacks. They point out all the vanity, uselessness and false value-creation involved with share buybacks.

There is another huge camp that is against debt. Any form of debt. They point out that debt is evil, is not free money and encourages you to spend what you do not have.

There is a huge camp that accepts debt as a necessary element of the capital structure but are against excessive leverage. They point out that a high leverage exposes the company when interest rates rise, and the interest rate becomes higher than the return on assets of the company.

All these camps join hands in condemning debt-financed share buybacks.

So, what’s with all the noise?

There are concerns that growing use of debt financed share buybacks pose a danger to the global economy. There is an estimated $330 trillion worth of debt out there borrowed by governments, companies, and households. This was around $250 trillion in Sep 2019. The world needs to de-leverage otherwise the global economy will fail to recover from the depression. Corona virus has already crushed the global economy.

Debt-financed Share Buybacks are increasing the total level of indebtedness for the private sector. The debt keeps piling up to unsustainable levels. Government finances are already bad, and the bulk of citizens are over-borrowed. If major corporations do not manage to lower debt levels, then the whole debt-based economic apparatus is doomed. One crack, and the global economy will tumble down. The system is too fragile. One “too-big-to-fail” type of default will cascade into a series of second round and third round effects enough to trigger a financial crisis.

The greatest noise, however, is a backlash from the public regarding how major corporations are using bail-out funds. Some companies are taking government bail-out funds (those stimulus package loans) and using the funds in conducting share buybacks. This is seen as bad management. People would like to see those stimulus package loans being utilized in boosting productive capacity, hiring more workers, keeping workers on the payroll instead of retrenching them, investing in R&D and rewarding employee productivity. Instead execs are seeing buybacks as the best way to utilize these funds which is basically short-selling the economy. The execs are effectively declaring that there are no current and future opportunities to be exploited using this money in this economy and the only prudent thing is to give this money to shareholders. It is giving the company and the economy a vote of no confidence. This is diametrically opposed the vote of confidence signal beamed by a share buyback in the early 2000’s.

The debt-financed share buybacks conversation has moved beyond economics and financial analysis. It is now a morality battlefield.

Ciao!