Tuesday, June 28, 2011

The Best Use of Corporate Cash: Acquisitions, Buybacks, Debt Reduction or Dividends?

"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett in the 1984 Berkshire Hathaway (BRKaShareholder Letter

Buybacks, if pursued with discipline in the manner Buffett describes, can work out very well for shareholders.

Unfortunately, in practice, buybacks don't always work out as well as they ought to for shareholders.

The reasons? Too often executives end up buying shares back, if not high, certainly not cheap. Alternatively, an expensive acquisition will be chosen when the company's own stock is right there available to be bought on the cheap.

Weak execution and the misalignment of owners (shareholders) and management objectives is sometimes the culprit.

Plenty of evidence supports this unfortunate reality.

Now, a senior management team doesn't generally come forward and say they behaved in ways contrary to shareholder interests. Management actions, examined objectively, in time reveal the real story.

Here's what Jason Trennert had to say in this Barron's article:

...buybacks may just "enhance the reputation of corporate treasurers as poor market timers," at a time when market cycles are growing shorter.

How management should allocate excess cash on balance sheet and future free cash flow for things like acquisitions, debt reduction, buybacks, and dividends is specific to each company. Of course, things like increases to capex/R&D/other expenses, in order to pursue organic business growth opportunities, is also an option when the risk-reward is clearly favorable.

The list of possible scenarios is long. Some companies have lots of debt to pay down. Others, little in the way of attractive internal investments yet otherwise strong businesses (See's Candies comes to mind if it were a stand alone public company). Alternatively, certain technology businesses can appear to have sound economics now but have to deal with a difficult to predict, fast changing, competitive landscape. For these businesses, holding excess cash might offer a bit of protection against a future fundamental shift that impacts core economics in a negative way.

Naturally, there are many other scenarios. One size does not fit all in capital allocation decision-making.

Having said that, buying back your own company's stock when it's clearly cheap is sometimes a great low risk way to create shareholder value.

"When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended." - Warren Buffett in the 1984 Berkshire Hathaway Shareholder Letter

Unfortunately, the track record is spotty at best as this Barron's article from earlier this year points out:

Beware The Buyback Craze

Buffett has said stock buybacks makes sense when they're selling below intrinsic value (calculated conservatively) and if the business and balance sheet are strong enough.

So not all buybacks work out for investors. Those one's that do not are mostly the result of ineptly buying high. When executed intelligently, buybacks work very well and also reveal that management actions are driven by shareholder wealth creation.

"By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders." - Warren Buffett in the 1984 Berkshire Hathaway Shareholder Letter

What's a good recent example of the expansion of domain if not necessarily shareholder wealth? The following may fit the bill. Check out this Barron's article on Sanofi's (SNY) offer for Genzyme. Here's what CEO Chris Viehbacher had to say when asked about buybacks on a conference call:

"I personally don't believe that buybacks add any shareholder value."

That acquisition may work out but that doesn't make this flawed thinking any less an issue for investors. The ignorance of basic math may seem puzzling but there is no shortage of CEOs that will let math get in the way of the desire to grow the empire even if it may cost the owners some wealth.

When a CEO is justifying the price paid and merit of a deal sometimes shareholders need to read between the lines.

My only somewhat sarcastic view is that the words strategic and/or synergistic used in the context of justifying the high price paid by the acquiring company for its target should be considered code for the following:

I'm going to overpay for an acquisition to grow this company at shareholders expense.

In too many cases, a company's own stock is selling below intrinsic value and could easily have been bought instead.

A straightforward, low risk, way to create per share value is available.

Yet the riskier voyage is chosen.

Personally, if I couldn't find a plane and needed to get across the ocean I'd take a ship. All too often, choosing an acquisition over a buyback seems the equivalent of attempting to get across on the back of a sailfish when a perfectly good ship is available.*

"Smart people aren't exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose..." - Charlie Munger in a speech to the Foundation Financial Officers Group

You just need a management team in place that knows how and when to allocate capital wisely with increasing shareholder value its real first priority.

Adam

Long BRKb

Related posts:
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Sanofi-Aventis: How Not to Spend $ 18.5 Billion
Buy a Stock...Hope the Price Drops?

Apparently, the sailfish can hit 68 mph for shorter periods of time. That's quicker than any other fish. So someone could, at least theoretically, get to their destination more quickly than on a ship. Obviously, that doesn't make it a brilliant alternative means of transport.
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