Blog on Investment Finance
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The Evils of Debt-Funded Share Buybacks
by Magnus Erik Hvass Pedersen, March 26, 2014
Companies can make debt-funded share buybacks. This has several effects on shareholder value. First, the interest payments reduce the future earnings. Second, the number of shares is decreased which potentially increases the future earnings and dividends per share. Third, the risk of default and bankruptcy is increased.
Jackson-Hewitt Tax Service
In fiscal year 2007, Jackson-Hewitt Tax Service (JTX) had record revenue of USD 293m, net income of USD 65m and Free Cash Flow of USD 63m (FCF is defined here as Operating Cash Flow minus Investing Cash Flow). The company made a partially debt-funded share buyback in the amount of USD 139m net of share issuance, while also paying dividends of USD 16m.
During 2007 JTX's market-cap ranged between USD 0.9-1.2b. This gives an earnings yield between 5.4-7.4% which is lower than the expected long-term rate of return of the S&P 500 which is perhaps 8%. So the future earnings of JTX would have to grow if the share buyback was to increase or even sustain value to long-term shareholders of JTX.
In 2008, JTX's revenue was USD 279m (decline of 4.8%), net income was USD 32m (decline of 51%) and FCF was USD 3m (decline of 95%). Yet the company made another debt-funded share buyback in the amount of USD 87m net of share issuance, along with dividend payouts of USD 21m. During 2008 the market-cap ranged between USD 0.3-1b. The share buyback was made at a market-cap above USD 0.7b so the earnings yield was below 4.6%, which again means that earnings growth is required if the share buyback was to even sustain shareholder value.
In 2009 and 2010 the revenue and earnings declined further and JTX filed for bankruptcy in 2011.
JTX went bankrupt because it had excessive debt; debt that was issued in order to make share buybacks; share buybacks that required future earnings growth if they were to even sustain shareholder value. In other words, JTX's debt-funded share buyback was a bet with little or no upside potential but a very large downside risk.
In 2012, Weight Watchers (WTW) repurchased 18.3m shares at a price of USD 82 per share for a total amount of USD 1.5b. This was a buyback of almost 25% of the company's shares. The market-cap at this share price was USD 6b.
In 2011, WTW's net income was USD 305m and Free Cash Flow was USD 360m (FCF, defined here as Operating Cash Flow minus Investing Cash Flow). This gives an earnings yield of 5% at the time of the share buyback. This was lower than the expected long-term rate of return on the S&P 500 which is perhaps 8%. If the share buyback was to merely sustain shareholder value then the future earnings of WTW would have to increase. But in the following two years the earnings decreased.
In 2012 the net income was USD 257m and FCF was USD 258m (ignoring an acquisition for USD 30m). In 2013 the net income was USD 205m and FCF was USD 262m (ignoring an acquisition for USD 84m).
The share buyback in 2011 was funded with debt. In 2013 the long-term debt totalled almost USD 2.4b. If the FCF for 2013 continues in the future then it will take about 9 years to repay the debt from FCF. In 2013 the operating income was about USD 461m and the interest expense was USD 103m which gives 4.5x interest coverage. The interest rate is variable but is partially hedged with an interest rate swap.
WTW's debt-funded share buyback likely destroyed shareholder value because it was made at a share-price that was too high. It also increased the risk of financial distress. Time will tell if WTW will continue to experience declining earnings and if this leads to bankruptcy as in the case of JTX. However, this uncertainty could easily have been avoided if WTW had not made the debt-funded share buyback.
Law and Regulation
Because of the potentially devastating effect of debt-funded share buybacks, it is imperative that the public is thoroughly informed about a company's plans, the amount and terms of the debt, as well as the price at which shares are bought back. Lawmakers must enforce such disclosure as companies do not offer it voluntarily. It should also be required by law that debt-funded share buybacks are always put to a shareholder vote. Lawmakers must also consider to what extent debt-funded share buybacks should be allowed or if share buybacks must always be funded from earnings.
Share buybacks should only be debt-funded when the company has little or no debt AND there is a high probability of the share-price being much lower than the value to long-term shareholders. Otherwise the share buyback has little or no chance of increasing shareholder value, while the debt increases the risk of financial distress which could require a future re-issuance of the shares at much lower prices, or it could even result in bankruptcy. In either case it destroys shareholder value.