Avoid Black-Hole Buybacks

"Stock buybacks are the simplest and best way a company can reward its investors."

— Peter Lynch

As the number of companies announcing stock buybacks has increased, investors will need to become more discerning about their effectiveness.  Buybacks are supposed to be bullish for stocks.  And who can argue with Peter Lynch, especially when Mark Hulbert of Marketwatch.com backs it up with hard data.  Last week, Hulbert wrote about the most comprehensive study of stock buybacks –   

…Perhaps the most prominent of such studies appeared in the Journal of Financial Economics: "Market Underreaction to Open Market Share Repurchases," by David Ikenberry and Josef Lakonishok (both from the University of Illinois at Urbana-Champaign), and Theo Vermaelen (at INSEAD, the French business school).

The latest studies indicate that the stocks of buyback companies have outperformed the market by nearly as much in recent years as they did several decades ago.

[Ikenberry] referred to a new study of buyback programs that were announced during the 11 years following the 1990 cutoff of his original study. (Note carefully that it is not yet possible to measure the four-year performance of buybacks announced later than 2001.) This latest research was conducted by one of his original study’s co-authors, Vermaelen, and one of his INSEAD colleagues, Urs Peyer.

Of particular note is what these researchers found when measuring investors’ immediate reaction to repurchase announcements. The amount in 2001 by which the average buyback company’s stock jumped following such announcements was higher than in any other year of their sample, suggesting that — as would be expected — an increasing number of investors are buying stocks in response to repurchase announcements.

Which is all well and good – it makes sense that companies that generate enough cash to buy back their stock should outperform the market.  However, many companies have been hiding behind buybacks as a means to keep investors happy and complacent.  In many cases, companies are simply throwing investors a "buyback bone" to keep them from revolting.  It seems that these days, buybacks are oftentimes used to distract value managers from coming to grips with underperforming business models and/or poor management. 

I call these "black-hole buybacks" – the board of directors is essentially trying to please shareholders by pouring money down a bottom-less pit rather than disappoint their stakeholders and restructure the company.  The problem with "black-hole buybacks" is that they only postpone the inevitable decline in the business and don’t create sustainable value.  First and foremost, investors still need to have confidence in a company’s business model and hopes that it can (or could) be successful.  No buyback will protect investors from a business in secular (read: permanent) decline.  And many businesses in this situation resort to buybacks rather than addressing the difficult and often painful changes needed for their businesses. 

The best example of this trend of "black-hole buybacks" is Furniture Brands (FBN).  The company is stuck in an industry with no pricing power, compressed operating margins, bankrupt retailers and increasing competition from China.  There is little hope of a change in any of these trends.  Furniture Brands itself is a mish-mash of underperforming brands cobbled together through a industry consolidation acquisition model.  Despite the fact that housing starts have been booming since 2001, the company’s sales have only increased about 10% over the past 5 years.  In the September 2000 quarter, FBN had revenues of $500 million and net income of $23 mln on 50.5 mln shares outstanding.  In the September 2005 quarter, the company generated revenues of $558 mln and net income of $10 mln on 51.7 mln shares outstanding.  So over the past five years, during the biggest housing boom we will ever see in our lifetimes, earnings have decreased by over 50%.  Granted, comparing one quarter over five years may not be indicative of a company’s performance…but in this case, it is. 

Every quarter, Furniture Brands dutifully reports that it bought back several million dollars worth of shares.  In fact, since October 2002, the company has announced $250 mln worth of buybacks.  Yet the number of shares outstanding has actually risen over the last five years.  So while the company has ostensibly "served" shareholders by buying back shares, its management has managed to increase the share count through underperforming acquisitions and stock option grants.  Instead of preserving cash and using the capital to cut underperforming brands, improve manufacturing and take the painful steps needed to return to growth, the company has virtually stood still for 5 years in a rapidly changing industry. 

Compare FBN with Ethan Allen (ETH), which operates in the same industry.  In September 2000, ETH reported $211 mln in revenues and $21 million in net income on 40.2 million shares outstanding.  In September 2005, ETH reported $258 mln in revenues and $17 mln in net income on 34.6 million shares outstanding.   ETH has been negatively affected by the same trends as FBN – revenues are up only marginally over five years and net income has decreased. Yet that company’s share count was reduced by almost 15%.  While net income decreased 20% over the past five years, earnings per share declined only 5% – $0.49 in Sep 2005 vs $0.52 in Sep 2000.   

ETH has clearly returned more value to its shareholders in terms of buying back stock and maintaining its earnings per share.  The odd thing is, if you bought ETH and FBN in the fourth quarter of 2000, neither stock would have provided you with much of a return.  In fact, ETH has barely outperformed FBN in the last five years as seen by the following chart. 

Source: Baseline

How could that possibly be?  ETH is clearly the better managed company.  Its management has returned much more value to shareholders and the company’s revenues and earnings have outperformed those of FBN.  The explanation is that the market already understands that ETH is the vastly superior company.  Its revenue and earnings multiples have historically been much higher than FBN.  While ETH has traded at an average 16x trailing earnings over the past decade, FBN has traded at an average 12x trailing earnings.  The same is true of price to sales and price to forward earnings, as can be seen in the two charts below.  The median price to sales over the last 15 years for ETH has been 1.4x and the median price to forward earnings has been 14.5x.  The median price to sales for FBN has been .6x and the median price to forward earnings has been 12.3x

Source: Baseline

This seems to be a very discouraging message for management teams, board of directors and investors.  Even if a company returns value to shareholders via buybacks, it does not automatically ensure stock out-performance if the valuation multiples already reflect that fact. 

But there is hope for investors.  Buybacks are a positive for investors but they cannot be analyzed in a vacuum.  Neither can earnings, valuation, sentiment or the overall market.  They all work together in determining where a stock trades.   

To highlight this point, I’ve chosen a third example from the furniture industry – American Woodmark (AMWD).  In this case, all the parts – earnings, valuation, and sentiment – worked together to provide a superior return for investors.  American Woodmark sells kitchen cabinets through Lowes, Home Depot and directly to home builders.  As furniture and appliance companies will attest to, this is an unenviable position to be in.  Home Depot and Lowes have had the same effect on prices as Walmart – namely, they have been a deflationary force that has driven down profit margins for all companies that sell through that channel.  The point being is that AMWD probably faced as difficult an operating environment as ETH or FBN.  Despite this, AMWD has thrived and the stock has outperformed the rest of the industry. 

AMWD outperformed for several reasons.  First, the company underwent a painful and long restructuring in the middle 1990s to transform the company from a typical capital and labor intensive furniture manufacturing company into an efficient, lean-manufacturing machine.  This transformation has allowed the company to build and deliver cabinets more cheaply and more quickly than many other larger manufactures.   The transformation was unpleasant for everyone involved – it included firing a significant part of the workforce and closing plants in several small towns.  However, the end result reduced the company’s manufacturing space by 90% – that is, the company used only 10% of the space it used previously to build the same number of cabinets.  The "lean and mean" operations allowed the company to double earnings in the latter half of the 1990s and double them again in the past five years. Revenues increased from $107 mln in the Oct 2000 quarter to $216 mln in the Jul 2005 quarter and EPS increased from $0.22 to $0.45 during the same periods.

Second, the company’s transition was under-appreciated and under-valued by the market.  The company’s earnings multiples were depressed because the market didn’t yet understand how completely the company had changed.  Not only did the market under-estimate the company’s earnings power, it under-estimated the quality of those earnings.  So in addition to rising earnings, the company’s multiple expanded as well. 

Finally, on top of the strong earnings growth, the company has used its cash flows to return value to shareholders through stock buybacks. The company announced four buybacks over the past five years totaling $40 million in stock.  While these buybacks haven’t lowered the sharecount, the company’s share count hasn’t expanded much either.  In Sep 2000, AMWD had 16.3 mln shares outstanding and last quarter it had 16.7 mln shares outstanding – pretty remarkable for a stock that has doubled in the past five years. 

So how does AMWD stack up next to ETH and FBN?  Amazingly well.

And despite its exceptional performance, the stock is still trading at lower multiples than FBN and ETH. 

The purpose of this exercise isn’t to recommend AMWD or not recommend ETH and FBN – even though the case for owning AMWD and ETH is fairly good (Disclaimer:  I own ETH for my clients).  The purpose is to highlight the fact that share buybacks don’t automatically mean the company is "increasing shareholder value" by announcing a buyback.  Like in Furniture Brand’s case, the share buyback can simply be a "mis-direction" because real shareholder value could only be created by addressing management problems or restructuring the company.  And oftentimes shareholders are just as much to blame for this trend as the boards of directors themselves.  Rather than hold a stock through an ugly and long restructuring, shareholders would rather see an instant payback in the form of a buyback. 

So as the flurry of buyback announcements continues, understand that a share buyback does not automatically mean that the company is returning value to shareholders if it is done at the expense of addressing more difficult operational problems.  But buybacks announced by growing companies, trading at reasonable multiples, are truly what Peter Lynch referred to as a "reward for investors".