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Buying Back Shares: An Admission of Defeat

Announcing layoffs along with a stock buyback – let’s think about what that means. AstraZeneca did that just the other day, and they’re far from the only ones in this industry (or others) spending billions to buy back their own shares while they’re cutting costs elsewhere.
We already know what the companies have to say about what it means. All you have to do is say “shareholder value” and you’re most of the way there. Mix in “continued commitment” and “cost containment”, fit ’em all together with a verb or two, and you’ve got yourself an instant press release. And we also know what the investment community thinks: they like it. Go back over the news stories that have come out when a buyback is announced, and all the quotes will be about how large the amount is, whether it’s in line with what people were expecting, or if it’s one of those good moments when the company is spending even more to buy back its shares. No one would be so foolish as to announce a truly inadequate-looking stock repurchase.
That’s a key point. As far as I can tell, share buybacks have two purposes. There’s the obvioius one of trying to provide some steady buying activity in the stock and (in theory) a floor for its price, while retiring shares to decrease the float (and increase earnings-per-share). But the other reason is signaling. “We think our stock’s worth buying at this price”, the company is saying, “and so should you. We care enough about our existing shareholders to spend money tending the share price for them. Please don’t sell us, or downgrade us. We’ll buy back even more – promise!”
Signaling is, I think, the greater of those two. There’s a lot of room to question the actual financial effectiveness of stock buybacks. As one person in that link notes, if you want to reward current shareholders with cash, you should pay them a dividend. Trying to keep your stock price up (even if the plan were to work) only really rewards the people who sell your stock and realize the gains. (See below for who some of those people are, though).
That signaling had better be worth something. It goes without saying, or should, that the money being used to buy back shares could also be put back into a company’s actual business. That’s another signal, one that makes me grit my teeth. To me, a stock buyback has always said “We’re willing to tell the world that we think that buying our own shares will provide a better return than investing in what we’re supposed to be doing for a living.” And why would you tell the world something like that? Isn’t that also saying “We can’t think of much else to do with this cash, what with our business in the shape it’s in, and parking it in an investment fund would be sort of embarrassing, So we might as well use it to bribe the Street. God knows it’s the only language they understand.”
There are other people willing to put it in just those terms. That “Marketplace” link above features a quote from William Lazonick of UMass-Lowell (note: affiliation fixed after original post), who’s not keeping his views bottled up:

“Here we have all these companies obsessed, basically with keeping their stock prices up, and saying the best thing that they can do with their money is spend billions of dollars on stock. And my view of that is, any company that says that they have nothing to better do with their money, the CEO should be fired.”

A CEO’s reply to that might well be that this attitude is why Lazonick’s a professor rather than a CEO himself. But is he wrong? Here’s a recent paper of his, which contends that the problem is that share buybacks are all too effective (update – that link appears to be broken, so here’s Lazonick at the Harvard Business Review on the subject). Lazonick says that the problem is tied to the increasing compensation of top executives in shares and options, and that using company money to prop up the stock price is, basically, market manipulation to reward the executives.
He has some figures from our own industry: From 1997 to 2009 “Amgen did
repurchases equal to 99 percent of R&D expenditures, Pfizer 67 percent, Merck 62
percent, and Johnson & Johnson 57 percent.” It could be worse – companies in the IT sector have often managed to spend even more than their R&D budgets on repurchases, partly because they increased the number of shares outstanding so hugely during the dot-com boom years.
One complication with the market-manipulation view is that stock buybacks don’t correlate very well with total stock returns. If anything, the correlation is negative: companies (and sectors) that spend the most on repurchases have lower returns. Of course, there’s a correlation/causation problem here – perhaps those returns would have been even lower without the buybacks. But there’s clearly no slam-dunk financial case to be made for repurchases.
Except one: that they’re often the easiest and least controversial use of the money. Companies get criticized if they sit on cash reserves, and they get criticized for missing earnings-per-share numbers. Why not try to address both at the same time? And without having to actually think very hard about what to invest in? I think that Pfizer’s Ian Read is being truthful when he says things like this:

Pfizer declined to make an executive available to discuss its policy. But in a statement, the company said it “remains committed to returning capital to shareholders through share buybacks and dividend payments.”
As for the cut in research spending in February, Pfizer said it has “accelerated our research strategy and made important changes to concentrate our efforts to deliver the greatest medical and commercial impact.”
In a conference call with analysts this month, Pfizer’s chief executive, Ian C. Read, said his company would “continually look” for acquisitions that would increase revenue growth. But in deciding how to use the proceeds from recent asset sales, he said “the case to beat is share repurchase.”

And that, truly, is a shame.

44 comments on “Buying Back Shares: An Admission of Defeat”

  1. PharmaHeretic says:

    But is such financial manipulation unexpected? Isn’t it the endgame of “shareholder” capitalism?
    Why should a senior executive or CEO care about the medium term, let alone the long term, when he or she can legally loot the corporation to stuff their own pockets through share-price manipulations? You didn’t think those people have a conscience or a larger vision- did you?

  2. darwin says:

    Can’t save money if you are public traded company…if they arent going to reinvest it in growth or distribute it in dividend, doesnt leave many options. It is proven that CEO investing in R&D is not real option and more of a fasade for quarterly pipeline demonstration purposes only. Discounted, easy and intelligent acquisitions are now sparse and the regulatory landscape, patent- and govt reimbursement pressures are schitzoid as ever. Call it a shame, but it is a business tactic that companies do to strengthen the voting privelages and profit distributions of each share. If the CEOs diluted outstanding shares by issuing more, you would be complaining as a shareholder of your own stock. I feel like I need an exorcism now that the demons have surfaced again. “Can’t stop what’s comin'”

  3. Anonymous says:

    Two additional points on this:
    A dividend is a better way to give some of the profits to shareholders. However, paying a dividend usually creates the expectation that a company will pay at least that amount of dividend each year. Reducing or stopping a dividend is a negative. Share buybacks do not set the same expectation, and can be a better way to “distribute” a large amount of cash to shareholders once. They are certainly less effective when used repeatedly.
    A share buyback also can remove the worry about ill advised acquisitions. They can signal that the pharma company is not going to go buy something stupid at a huge premium, as well as actually take away management’s ability to do so with cash.

  4. Dumb question says:

    #3 – Along those lines, do share buybacks actually reduce divdend payouts long term, that is since there are less share outstanding could buybacks be part of a long term plan to financially strengthen a company since cutting dividends is a more difficult option? Not that I’m saying that’s what AZ is doing, but since I know little of economics share buybacks sounds like a good option in a down market to reduce long term financial obligations to shareholders. But I’m guessing from the commentary above that I’m wrong.

  5. Derek,
    Isn’t there a 3rd possibility? Right now big pharma stocks are at pretty low valuations and some would say they are underpriced.
    If you think your future growth rate will increase and the public’s appetite for pharma stock will improve, you should buy your own stock at a low valuation, wait until market mood improves, then sell at a premium. Voila, you just raised a bunch of money at low cost.
    Mike

  6. Anonymous says:

    #4 – What you suggest is true, that if you have fewer shares and keep your dividend per share the same you will be committed to pay out less over time.
    However, the thinking is probably pretty simple for a pharma management team. They have lots of cash, and they can’t really sit on it indefinitely. They can raise the dividend, but must then keep it high or disappoint shareholders. They can reinvest in R&D, but shareholders are pushing for less R&D spending as a percentage of revenues rather than more because (rightly or wrongly) investors view pharma R&D as inefficient. They can go out and buy another company, but most quality target companies large enough to move the needle for a pharma have already been eaten or are very expensive. Very often the path of least resistance is a share buyback. Maybe it is not hugely effective, but the other options often look worse.
    Maybe the best way to go is private pharmas, so fewer of the shareholder demands influence decisions. Boehringer is a great example. However, this is essentially a company that protects a family fortune. They want 10% growth every year forever with limited downside risk. They can take a 10 year view of the business in ways that public investors won’t tolerate.

  7. john schilling says:

    Share buybacks would also seem to be an appropriate way to deal with the fact that, sometimes, the right thing for a company to do is to shrink. Which, yes, is often seen as an admission of defeat – if you believe the hype, it is every company’s destiny to grow, grow, grow until it owns the entire universe. To stop growing is to die.
    Reality doesn’t always work that way. And when you find that your company has a long and prosperous future ahead at half its present size, what are the options? Let your per-share price drop by fifty percent and hope the market doesn’t panic? Use your current surplus to expand into a new market and create a hybrid company whose sole virtue is that it preserves the size of the original? I’m thinking maybe a buyback, accompanied by layoffs, is the way to go.
    Whether or not AstraZenica actually has a long and prosperous future ahead at a fraction of its present size, is another question.

  8. sigma147 says:

    On the lines of what others are saying, stock buybacks can often be a protective measure. It’s not good to be cash rich with a low-valued stock price – you become a target for a hostile acquisition. It’s admittedly another aspect of your point that the cash should be applied productively to bolster stockholder value through business activities, though. Lacking that, best not be caught with pockets full of cash in a dark alleyway.

  9. Derek Lowe says:

    Biotechtranslated (#5) – that’s true, but no one ever actually sells shares of their own company on the open market. Lazonick mentions this, too, in the context of signaling – that would be sending the signal that “We think our shares have gone up about as far as they can for now”, and no one ever wants to send that one out. Generally, if you want to take advantage of a high stock price in that way, you just issue new shares – your cost basis then is more or less zero.

  10. Joel West says:

    Perhaps this is less of an indictment of the CEOs and instead one of the last gasps of the traditional pharma model.
    What do companies do with big wads of cash? They buy shares of their own or they buy other companies. At least the former tend to be cheap for companies that are in as much trouble as these companies.

  11. Taking a closer look at Lazonick’s paper, he seems to have a serious anti-corporate/pro-gov’t bias.
    What’s up with his recommendations at the end of the paper?
    1. Ban stock repurchases? OK
    2. Index stock options to a an indicator of innovation performance? Such as???
    3. Regulate the employment contract to ensure workers are compensated for innovation? Translation: force companies to compensate the “right” way
    4. Make work programs for skilled labor? I’m sure we’d still have a robust buggy whip industry if we had only done this in the 1800s.
    5. Taxes gains made from innovations to fund gov’t programs? I think we already do this.
    Has Lazonick ever run a business of his own? These seem like the ideas of a man who has basked in the warm embrace of tenure his whole working life.
    Mike

  12. Derek Lowe says:

    Biotechtranslated (#11): He does seem to, which probably doesn’t exactly make him stand out at UMass. Note that he also doesn’t let a mention of the drug industry go by without mentioning the budget of the NIH. I think he’s better at identifying the problem than he is at coming up with something useful to do about it.

  13. Justanothernyer says:

    Derek,
    First off let me say I very much enjoy your blog.
    Two points though.
    First, what John Schilling (#7) said is correct. What would you suggest a company do when it actually thinks the long term return on investment is below the market return? It can destroy a lot of capital with pricey acquisitions, deliver sub par returns until shareholders revolt or return the capital to shareholders for reallocation. You can disagree with their assessment of the low ROI on pharma research. If, however, they are correct, what would you suggest that they do?
    Second, your comment number 9 is incorrect. It is not a matter of cost basis. Issuing new shares and selling old shares are economically identical and would send the identical signal.

  14. Boghog says:

    Another way of looking at it is that the pharmaceutical sector has become a mature industry. Signs include earnings growth in line with most of the rest of the economy and as a consequence lower price-earnings ratios. Such companies try to compensate with mergers, paying higher dividends, and share repurchases.

  15. daveh says:

    One factor often overlooked… The repurchased shares can be used to grant lots of options without an additional stock offering. This keeps the company’s financials lookin good, when providing extravagant compensation packages.

  16. bbooooooya says:

    At least they’re admitting they have a problem using capital effectively. This can be a first step to solving the problem…..

  17. Anonymous says:

    #16 I agree, a first step….
    It is a shame Derek that the best use is to ‘give the cash back’ but look, Pfizer spent over $70Billion on R&D in the last decade and released 3 drugs (Sutent, Champix & Miraviroc). These drugs don’t make a lot of money. We can argue the reasons why this expenditure didn’t find more – in fact we need to sort this out – but if you didn’t find many drugs with $70BB why do you think 80, 90, 100BB will help??
    I thought I’d never agree with Ian Read on anything but he is right, until ‘we’ sort out the R&D mess, the cash should return to the shareholders.

  18. Esteban says:

    Daveh (#15) is on to something — at least in Tech, share buybacks are done in large part to offset the shares created by compensation packages.

  19. Hap says:

    1) I wonder how you accelerate research by cutting its staff unless you’re discussing research by Asian CROs into potential clients, by your research staff into other opportunities, or by your stockholders into what other stocks might be good places for money in the long term. I don’t think any of those options help the company, though.
    2) A comment in a previous post complained that cutting the pay of CEOs for bad performance would prevent companies from being able to hire qualified candidates. How qualified do you have to be to plead ignorance on how to run (let alone improve) your business? I would have figured almost anyone could do that. (I know there are Dunning-Kreuger possibilities, but I’m sure it wouldn’t be hard to find someone who knows little enough about a business to not be overconfident about their knowledge.)
    3) If government’s legitimacy ended when it found it could bribe the people with their own money (De Toqueville, via Clancy), what do stock buybacks say about the stock market?
    4) I guess actually making useful things and getting paid for them is an outmoded business model.

  20. Childred Shortly says:

    #17, perhaps we should be amazed that a drug company can market even three drugs during a period when they have seven major research reorganizations and close multiple major research sites. Science takes time and requires a tolerance for risk, characteristics day traders rarely embrace. Benchmarking the past ten years against shell games like the real estate market and the Chinese economy is for dupes and con artists.
    Face it, the “Pharma R&D isn’t adequately productive” meme is yet another Harvard business School pickpocket’s stall, and the sainted shareholder is just another mark.

  21. Childred Shortly says:

    #17, perhaps we should be amazed that a drug company can market even three drugs during a period when they have seven major research reorganizations and close multiple major research sites. Science takes time and requires a tolerance for risk, characteristics day traders rarely embrace. Benchmarking the past ten years against shell games like the real estate market and the Chinese economy is for dupes and con artists.
    Face it, the “Pharma R&D isn’t adequately productive” meme is yet another Harvard business School pickpocket’s stall, and the sainted shareholder is just another mark.

  22. DrSnowboard says:

    ‘Predictive innovation’isn’t going to rescue the share price, nor is cooperation (code for we are circling the sluice, help us out guys..).
    (http://www.nature.com/news/success-through-cooperation-1.9924?WT.ec_id=NEWS-20120207)
    Anders Ekblom to leave within 12 months as per Jan Lundberg? Seems a classic ‘special projects’ profile raiser….ie personal advert
    Ex-pfizer cabal now in charge, watch for design chemists retained, synthetic chemists discarded. Key skills will include phone manner, influencing at a distance and independence..but not of thought.

  23. Morten G says:

    Isn’t research on organizations starting to focus on what optimal sizes are for efficiency, rather than what efficiency increases can be had by consolidation? Of course this runs counter to the CEO’s interest which is to be the head of the biggest organization possible, not the most efficient.

  24. BigSky says:

    I’ve wondered about this buyback tactic myself and wanted to add another wrinkle to the discussion. Buybacks increase the value/share, and the net worth on paper, for shareholders without imposing a tax penalty today. Dividends would be subject to tax capture (at lower rates than my labor… a discussion for a different blog) but the increased value to existing shares wouldn’t be captured until those shares are sold and the shareholder has control of that action and can plan for it.
    But I still think the buyback tactic is an action defensive in nature and primarily aimed at appeasing Wall Street and the Executive Team. It raises zero new money for use by the company(by definition it reduces that money), Wall Street gets a percentage, analysts are happy they have a new event to churn for clients and most importantly, executive compensation tied to stock price increases.
    Buybacks create not a single new lead or product/widget. Not that anyone cares though.

  25. Dave says:

    There is a part of me that is inclined to agree with our host’s assumption that this says management isn’t very good. Also, it may well be happening so much because it’s in managements best interests and not the shareholders.
    However, on the other side, it’s getting more and more expensive to develop new drugs. Getting regulatory approval for a new drug is getting harder all the time.

  26. AC1 says:

    Buying shares to cancel can be a lot more tax efficient for shareholders who may be stuck with higher dividend taxation than taxes on capital gains.

  27. Brent Buckner says:

    Last I heard, U.S. tax policy (and that of some other countries too) taxes dividend distributions but not share buybacks.
    If a company’s directors determine that it is too big for its market opportunities, shrinking may be a good option. This shrinking may involve reducing cash on hand and employees. Share buybacks may be preferable to dividends for reducing cash on hand due to tax reasons.

  28. Occam's Beard says:

    Companies issue stock to acquire capital they need; why shouldn’t they retire stock if they don’t need the capital? A company can’t expand indefinitely, and at that point excess capital just means they’re in essence becoming a bank. If that’s not in their expertise, they’d be foolish to do so.

  29. Ken says:

    If they can no longer invest profitability in their own company due to altered circumstances (gee, has the drug industry encountered any altered circumstances lately?), there is every reason to return some cash to investors; that means either a dividend or a stock buyback.
    IIRC, tax rules make stock buybacks a much better deal for the investors, since dividends are taxable in total to the stockholder, while stock buybacks are only taxable to the extent of a gain, and that at capital gains rates.

  30. zeke says:

    Companies do buybacks for a few reasons – all of which are the result of having tons of cash without enough high return internal investments to use that cash.
    Firing the CEO because of that is a stunningly ignorant statement. Of course, he knows better and just said it to drum up traffic or some such. Pfizer is a good example of a company that has been generating tons of cash on current products but not been able to create new – sending more money down an unproductive and already well funded R&D path would be worth firing not giving money to shareholders.
    Buybacks are preferable to Dividends in two ways although not always preferable
    1) They aren’t a permanent commitment – extra money now to spend on buybacks doesn’t mean extra money later – reducing dividends later is a killer to a stock – so why increase it now.
    2) Buybacks don’t have the double taxation that dividends do so its a somewhat cheaper way to give cash to shareholders

  31. Sisyphus says:

    I think BigSky and Brent Buckner have part of the answer. Dividends are taxed, so many companies see share buybacks as a more tax-efficient means to return money to shareholders. As other commenters noted, the share buyback also avoids raising and then lowering dividends (though some companies use special dividends instead), which is strongly disfavored by many investors.
    I understand there to also be some means by which foreign subsidiary-held cash can be used for share buybacks. Because of the non-territorial rules that the U.S. uniquely has among major economies, that money can’t be used for dividends without paying substantial tax (usually 35%) on it. If a company can avoid 35% tax internally, and its shareholders avoid an additional 15% tax on dividends, that’s a pretty compelling reason for a company to choose inefficient share buybacks over the more efficient dividends.
    If many companies seem to be doing something stupid, it’s more than likely a result of bad policy or other bad incentives, after all.

  32. Mark of Lombard says:

    Seems like buying back stock would be a sensible thing to do if you felt that coming years will see high rates of inflation, so that owning cash is a bad idea, but that the after-tax profit from expanding the business doesn’t justify the risk.

  33. PacRim Jim says:

    Corporations give stock to key employees.
    Corporations buy it back for at least two reasons:
    To have enough of their stock to give away to future key employees.
    To keep current key employees by propping up the stock in difficult times.
    As always, other factors must be taken into consideration.

  34. Dave says:

    Sometimes a stock buyback is the right and honest thing to do. If a new technology is likely to sunset your industry in ten years’ time (e.g. you’re making color film in 1995), squeeze out all the profit you can before then and use it to cash out the stockholders. Or, taking Prof. Lazonick’s advice, reinvest the profits and watch the stockholders and employees get annihilated.

  35. bobby b says:

    “As far as I can tell, share buybacks have two purposes.”
    Tell harder. I can think of at least one more purpose right off the top of my head.
    Spare cash is normally a target. In our present political and financial environment, it’s a huge, bright red, bells-n-whistles target that screams “take me!” as you desperately try to hide it.
    We know for certain that our ruling political class is searching high and low for money it can grab and hand out to people in exchange for vote dollars. We’ve tapped out all of the easy taxable events, we’ve cut a swath through the slightly tough confiscations, and we’re deep into the improbables and they’re still not slowing down. BO and the Dems need cash. Now.
    To have cash hanging out there in plain sight today would be grossly negligent on the part of any CEO or CFO, because in a world controlled via the mysterious, corruptible administrative agency rule-making process, your cash can be noticed, targeted, characterized as something you don’t deserve as much as someone else might deserve it, and taken from you in a tax, a fee, a penalty, or, in the Sebelius/Jackson/Obama model of looting, a simple in-your-face blackmail demand.
    Why do you think so many corporate butts are so firmly planted on so many corporate checkbooks? No one is expanding personnel, or facilities, or even work volume, because no one is going to risk letting the corporate assets out of the basement vault in such a completely unpredictable governmental environment.
    If BO wins re-election, look for complete stagnation or worse for four more years, as we all sit on our cash and maybe spend some of it on ourselves but put nothing out there at risk of getting ripped off. We don’t HAVE to have taxable events, now, do we? Second-worst case, many people can live off of capital until 2016, easy. Worst case, people might simply decide that it’s not getting better, that they’ve “made enough”, and that it’s time to shut down the firm and liquidate and go enjoy that beach place.
    Point is, in this environment, taking that chunk of cash out of the vault and buying back shares is a prudent and cautious and praiseworthy course of action for many CEOs. And that’s what you’re seeing.

  36. Chandra says:

    “If BO wins re-election, look for complete stagnation or worse for four more years, as we all sit on our cash and maybe spend some of it on ourselves but put nothing out there at risk of getting ripped off.”
    You mean by another TRILLION dollar war of aggression? I don’t think so.

  37. Hap says:

    Only if you’re lucky – I think the last one(s) cost $4T.
    The “give lots of money to the richXXXXXXXXXjob creators and they’ll create jobs” policy doesn’t seem to have worked real well – therefore, by Republican logic, it’s time to try it again (because this time it’ll work). We need to keep trying until we become Victorian England.

  38. Jeffrey Soreff says:

    “We’re willing to tell the world that we think that buying our own shares will provide a better return than investing in what we’re supposed to be doing for a living.” – Well said!
    At one point in my life, I worked at a start-up. Start-ups raise money by selling stock, with the intent that they have such good ideas that they believe they can earn a better return on this money by investing in their business than could be earned with the same cash in the financial markets. A stock buy back is precisely the reverse of this, and says precisely the reverse about the business.

  39. hibob says:

    “tax rules make stock buybacks a much better deal for the investors, since dividends are taxable in total to the stockholder, while stock buybacks are only taxable to the extent of a gain, and that at capital gains rates.”
    But there’s also a big difference between an immediate guaranteed return and a bump to a risky investment you’ll be holding for some time.
    Say a $100M dividend results in ~ $30M in income tax, netting the shareholders $70M today. How often does a $100M stock buyback actually raise the eventual sales price of all the remaining shares (when they eventually turn over) by more than $70M(net present value)?

  40. Theo Vermaelen says:

    This article shows so much ignorance about buybacks that it is pathetic. For example, the statement that buybacks benefit sellers not long term investors. The empiricial fact is that companies that buy back their own shares beat the market in the long run, on average. So, if anything, long term shareholders benefit at the expense of sellers.

  41. anonymous says:

    I can’t say how many times I have seen the advertising ploy of company boards announcing in a fancy press release: “Board approved buyback of x million shares of stock” These announcements are similar to the many continuous freely posted advertisements of “open positions” on the internet that never seem to go away, but create the appearance of a healthy expanding company.

  42. hibob says:

    @#40:
    “For example, the statement that buybacks benefit sellers not long term investors. The empiricial fact is that companies that buy back their own shares beat the market in the long run, on average. So, if anything, long term shareholders benefit at the expense of sellers.”
    Cite?
    For shareholder ROI of stock buyback vs dividend, that is, not vs crazy mergers and acquisitions. Adjusted for NPV.

  43. hibob says:

    @#40:
    “For example, the statement that buybacks benefit sellers not long term investors. The empiricial fact is that companies that buy back their own shares beat the market in the long run, on average. So, if anything, long term shareholders benefit at the expense of sellers.”
    Cite?
    For shareholder ROI of stock buyback vs dividend, that is, not vs crazy mergers and acquisitions. Adjusted for NPV.

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