Buyback Trend

Happy Investors, Heavy Debts

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  • Why it matters

    Why it matters

    Cheap money policies have U.S. companies going far deeper into debt than ever before, but when interest rates increase, investors are in for a rude awakening.

  • Facts

    Facts

    • Low interest rates have multi-national firms borrowing large sums to finance stock buybacks.
    • The trend has arisen partly due to activist shareholders demanding greater returns.
    • Debts will continue to grow until the Fed changes increases interest rates to make the trend less attractive.
  • Audio

    Audio

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When Google changed its name to Alphabet in August, management presented investors with an unusual bill.

The new holding company led by Larry Page bought back its own stock amounting to $5,099,019,513.59 in the fourth quarter. That amount wasn’t chosen by chance: It’s the square root of 26, the exact number of letters in the alphabet and Google’s new name.

What seems like a playful bit of whimsy will cost the renamed company almost one-third of its net annual profit of more than $15 billion, or €14.1 billion, while creating headaches for other companies. But this kind of move has become a trend.

Handelsblatt’s calculations confirm that publicly traded companies increasingly are piling up debt to please Wall Street investors by purchasing back stock and doling out dividends. Fewer shares in circulation result in a short supply of stock and increased earnings for each share.

“In the short-term, the buyback creates greater demand, even when the stocks themselves are not at all attractive,” said Howard Silverblatt, the leading index analyst at S&P Dow Jones.

And almost all companies are buying their own stocks.

Microsoft, Oracle and Qualcomm have all borrowed $10 billion from themselves over the past four quarters for stock buybacks. McDonald’s will spend about $8 billion this year to buy back shares and pay dividends, which is twice what the fast food chain nets in the same time period.

At General Electric, $90 billion will be siphoned off by stock buybacks and dividends over the next three years despite profits of barely $9 billion in the current fiscal year. After a drop in profits, agrochemical and biotechnology giant Monsanto announced it would lay off 2,600 workers, yet bought back $3 billion in stock.

These financial acrobatics will inevitably reach their limits when the current historic low interest phase ends in the U.S.

Activist shareholders demanding high returns are pressuring companies, but the U. S. Federal Reserve Bank also is fueling the trend. By pumping more money into the markets at zero interest and purchasing government bonds, the Fed has helped suppress the rate of return for stocks.

And then there is IBM. Since 2012, the ailing IT giant has bought $44 billion in stocks and paid out another $12.1 billion in dividends, even though chairman, president and chief executive Virginia Rometty admitted the company will not meet its economic forecast for the year, as the net profit has dropped by 50 percent compared to 2014. To finance the spending frenzy, IBM sold $32 billion in stocks. In three years, the debt burden has risen from $10 billion to $40 billion.

IBM, which is paying annual interest of between one and just under three percent for its bonds, has seen a lucrative business develop. For every share bought back – which IBM no longer needs to pay dividends on – the company spends $4.50 less per share. Since the supply of stocks has been reduced in the past three years by around 310 million shares, the company is saving nearly $1.4 billion in dividends.

The trend is unmistakable. Until the 1980s, American companies put an average of 2 percent of profits into stock buybacks. During the stock market boom of the 1990s, the percentage increased to one-quarter and this year it will climb above 50 percent to $600 billion among the largest publicly traded firms. An additional $500 billion will go to stockholders as dividends, which is at least $100 million more than the companies are expected to earn in 2015. Only once before in the economic history of the U.S. – in 2007 –  have American companies spent more on buybacks and dividends than they earned.

As a consequence of the cheap money policies, companies have gone far deeper into debt than ever before. Within 10 years, the liabilities of America’s 500 largest publicly traded firms have doubled to $3.5 trillion. Even General Motors, the ailing automaker saved by the federal government when it became insolvent in 2009, has announced a $5 billion buyback program, though the effort falls short of the $8 billion demanded by activist shareholder Harry Wilson. GM’s liabilities have almost tripled in three years to just under $47 billion. Since 2014, the automotive giant and its financing subsidiary have sold bonds worth $18 billion to investors.

But the record debts don’t mean the companies are threatened by insolvency. On the contrary, cash reserves of the 500 firms now total a record $16 trillion.

Apple and Microsoft already have proven that record debts and record cash reserves are not mutually exclusive. Microsoft’s cash reserves have grown to $96.5 billion while Apple has soared even higher to $205.6 billion. Over the past five years, the tech giants have repurchased $157 billion in shares, which is equal to the worth of German heavyweights BMW and Siemens. Carl Icahn, a major, high-profile American investor, vehemently demanded Apple chief executive, Tim Cook, buy back more shares, which led the company to ramp up its current program to $140 billion. Company management has purchased $30 billion in stocks in 2015 alone.

Both Apple and Microsoft finance buybacks with credit, not cash. “To repatriate our foreign cash under current U.S. tax law, we would incur significant tax consequences and we don’t believe this would be in the best interest of our shareholders,” Luca Maestri, now senior vice president and chief financial officer at Apple, explained at an earnings call in 2014. If the world’s most valuable company declared its worldwide earnings to the U.S., it would face a 35 percent tax bill. Microsoft is in the same position.

“Both are taking advantage of very, very favorable financing conditions,” said Jim Kochan, chief fixed-income strategist at Wells Fargo. Since early last year, Microsoft has borrowed $23 billion through low interest loans while Apple borrowed $40 billion over the same time period with investors receiving returns in part of less than 0.5 percent.

In just three years, Microsoft’s liabilities have tripled to $35 billion. They grew from zero to $64 billion at Apple. Almost all U.S. companies with strong foreign markets have increased their liquidity and debt load.

But these financial acrobatics will inevitably reach their limits when the current historic low interest phase ends in the U.S. Then, companies will have to cut back on their lavish and ever-increasing gifts to investors.

 

Ulf Sommer reports for Handelsblatt on companies and financial markets. To contact the author: sommer@handelsblatt.com

 

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