Lorillard Annouces Larger Buyback…Are Buybacks Worth The Trouble?
Lorillard announced recently that they are doubling their stock buyback program from $500M to $1B. This aggressive program will take out about 6% of the outstanding shares just this year, assuming the stock price stays near to where it is now. The question is, are buybacks good for companies and shareholders or are they simply financial engineering that hides true company performance? Like anything else, it depends on what your viewpoint is, what you want out of your investment and what kind of company is doing the buyback.
I would make the case that buybacks are a great strategy for increasing shareholder wealth for a company like Lorillard, though it isn’t necessarily the right strategy for many companies.
When Share Buybacks Work
Share buybacks work for companies that have the following criteria, but primarily for companies that have the first one which is the highest quality, stable earnings. Note here that high quality means stability and predictability and not necessarily growth. If you are a growth investor, you are looking for that spark that catapults a company into a larger and larger company. Share buybacks are seen as counter productive because the company should be using every last dollar to make the sales and profits as large as they can be, not reducing share count. In fact, growth companies typically increase their share count over time to raise additional capital to expand the business.
Here’s what you would look for in an investment that would make it worthy of share buybacks:
- High quality, stable, predictable earnings.
- High margins.
- Management commitment to actually reduce share count (in some cases buybacks merely soak up stock awards that increase share count).
- Low cost of buyback funds.
Sometimes, buybacks are sometimes not free because they are not funded by retained earnings. Many companies today are borrowing at low interest rates to buy back higher cost shares. In this case the math works because there is a large spread between the two. This is not unlike a similar situation for the consumer home buyer who gets a mortgage. The buyer borrows cheap money to buy an appreciating asset, plus getting a tax deduction to do it.
When Share Buybacks Don’t Work
Share buybacks don’t work for the same reason that you might not want to invest in a stock in the first place. If a company uses its retained earnings to buy shares back at high prices in an uncertain or deteriorating business, then it can be wasted money. An example of this is Best Buy (BBY) which in the past spent billions to buy back shares. Best Buy’s business is in the retail consumer space in a highly cyclical business with intense competition. The buybacks couldn’t increase shareholder wealth because the earnings picture isn’t that strong.
Companies like ExxonMobil have managed to make buybacks work because even though they are in an economically sensitive business. The shares are never really are expensive on a P/E basis. Plus, ExxonMobil does a great of job of increasing earnings over time to earn its P/E.
How Share Buybacks Increase Wealth
The premise of a buyback is that retiring shares causes every shareholders earnings percentage to increase. So, as a shareholder your earnings go up every time a buyback is initiated. Because you are investing in a high quality business, you can count on getting this earnings adjustment every year going forward (and hopefully even more as time goes on) . In the case of a company such as Lorillard, you can a get an even more significant increase in earnings share when you combine it with dividend reinvestment because the payout ratio is very high.
To demonstrate this, consider an investment in Lorillard that was made say at the beginning of this year @$38/share.
Jan 2013, $38/share, 100 shares:
Earnings Per Share: $3.11, 6%/year organic growth
Total Earnings: $311
Earnings Yield: 8.2%
Dividend Yield: 5.8%
Buyback Percentage: 3.0%
Since the share buyback goes to retiring shares, the shareholder yield is 8.8%, which is the return expected if the business simply stood still going forward. Not bad.
Look what happens after accounting for the growth, buyback and dividend reinvestment:
Earnings Per Share: 3.11*1.06*1.03 = 3.40
Dividend Reinvestment (@$40/share): 5.5 shares.
Total 2013 Earnings: 105.5 shares, 3.40/share = $359
Total 2013 Return: $359/311 = 15.4%
What this means is that I could expect to increase my earnings on this investment by 15% this year. Note that this ignores what is seemingly an important details: stock price. However, in the end this really doesn’t matter that much. The stock price is the level at which you can buy additional shares, it is a means to get more earnings.
The important financial amounts here are the increase in the earnings and the increase in the dividend. Assuming LO increases the dividend at the end of the year at the same rate as earnings increase (3% buyback + 6% organic growth), the earnings on this investment would increase by almost 15%.
Increase In Share Buyback
Now that an increased share buyback was announced by Lorillard, the numbers get even better. The buyback percentage isn’t 3%, but is likely to be 6% or more. When the company buys back shares or if you reinvest, the additional earnings increase depends on share price which of course can’t be predicted. For this case, I will assume a higher stock price for the buyback @$44/share. Let’s try these numbers again:
Earnings Per Share: 3.11*1.06*1.06 = 3.49
Dividend Reinvestment (@$44/share): 5.0 shares.
Total 2013 Earnings: 105.0 shares, 3.49/share = $368
Total 2013 Return: $359/311 = 17.8%