July 18, 2007

Boom in Buybacks Helps Lift Stocks To Record Heights

By PETER A. MCKAY and JUSTIN LAHART July 18, 2007; Page A1

Companies are buying back their shares at a furious pace, one of the big reasons the Dow Jones Industrial Average is pushing toward 14000.

The question is, how long can they keep it up?

In recent weeks, companies as diverse as oil producer ConocoPhillips, health-care products giant Johnson & Johnson and discount retailer Wal-Mart Stores Inc. have announced ambitious buyback plans. In the first quarter alone, companies in the Standard & Poor's 500-stock index spent nearly $118 billion to repurchase their shares, more than in any previous quarter.

Companies have increasingly resorted to buybacks -- which boost stock prices and per-share earnings by reducing the supply of stock in public hands -- as a way to return cash to shareholders. In doing so, they have supercharged the stock market's rally. (See related article1.)

Yesterday, the Dow industrials broke through the 14000 mark for the first time ever before slipping back to close at 13971.55, up 20.57 points, their fourth consecutive record close.

Many analysts and investors question how long the buyback boom can continue, and how much support stock prices can derive from buybacks over the long haul.

Some companies are financing their share repurchases with borrowed money, which is likely to get more expensive if interest rates continue to rise. Meanwhile, corporate-profit growth has slowed this year, which will limit the cash available for buybacks.

'Want to Be a Believer'

"I want to be a believer in buybacks," says S&P analyst Howard Silverblatt. "The problem is that the track record is not there" for stock buybacks to be the underpinning of a long-term bull market.

The surge in buybacks began in late 2004, aided by low interest rates and easy access to cash, but it has since picked up pace. Share repurchases have topped $100 billion for six straight quarters, a streak that seems likely to continue once data for the just-ended second quarter are in hand, S&P analysts say.

Companies announced $157.4 billion of buyback plans during the quarter, up nearly 58% from a year earlier, according to Thomson Financial. The total represents the maximum authorized for share repurchases over a given period. While buyback announcements typically boost share prices, companies don't always repurchase all the stocks they are authorized to buy.

Some of the biggest programs unveiled in the second quarter were launched by Home Depot Inc. ($22.5 billion), Wal-Mart ($15 billion) and General Electric Co. ($8 billion). All three companies are components of the Dow. In the current quarter, they were joined by Johnson & Johnson, which announced a $10 billion buyback earlier this month.

The $117.7 billion that S&P 500 companies spent buying back their shares in the first quarter was up more than 17% from a year earlier and about twice what they paid out in dividends.

Some investors prefer buyouts to dividends because dividends are taxable, but there is no tax due on a share buyback unless investors sell their shares. Amid rising profits, however, many companies have increased their per-share dividends too.

The dividend yield of the S&P 500 -- or dividends per share as a percentage of the share price -- has risen slightly since late 2004, when total buybacks pulled ahead of total dividend payments. It now stands at 1.8%, up from 1.7%, still relatively low by historical standards.

Because they tend to increase per-share earnings and stock prices, buybacks can be advantageous for corporate executives, whose compensation may depend at least in part on achieving profit and share-price targets. They can also benefit executives with large holdings of stock options. After a buyback, the number of shares those executives would get from exercising their options represents a bigger stake in the company.

Insiders, corporate officers should have a good sense of what their company is worth, and whether its share price reflects that, says Jeffrey Bronchick, chief investment officer at Los Angeles-based money-management firm Reed, Conner & Birdwell. If the company has cash to spare and it considers its shares undervalued, a buyback makes sense. If, on the other hand, its stock is expensive, paying a dividend makes more sense, he says.

Mop Up Shares

In practice, companies don't always act so rationally. They often buy back shares when stock prices are high because they have cash available. Or, they may sell shares to the public when prices are low to raise cash. A common practice during the 1990s was to use buybacks to mop up shares generated by employees exercising stock options as a way to prevent earnings per share from being diluted. Companies also sometimes buy back shares as a way to hit earnings per-share targets.

In some cases, companies -- and the nation's economy as a whole -- might be better off if they spent their money on new plants and equipment, rather than retiring shares, says Douglas Cliggott, chief investment officer at Greenwich, Conn., money manager Dover Management.

"In many cases, going the share buyback route is effectively throwing up your hands and saying, 'We give up, we don't know how to grow,'" he says. "Does it really make sense that a current-day industrial conglomerate should be buying back stock rather than trying to improve its fundamental position in the industries it is operating in?"

Just as private-equity firms typically finance their acquisitions by issuing debt backed by the companies they buy, many U.S. companies are raising the amount of debt on their balance sheet through buybacks while reducing their number of public shares.

Federal Reserve figures show that nonfinancial companies took $128 billion worth of stock off the market in the first quarter. During the same period, they took on $130 billion in debt.

Companies don't appear to be using those borrowings to finance new plants or equipment, says Northern Trust economist Paul Kasriel. "The data support the view that corporations are stepping up their credit-market borrowing in order to finance their share buybacks," he says.

In some cases, companies may be doing so to keep themselves from becoming takeover targets for private-equity firms. In other cases, the strategy may merely reflect a view that the company can easily afford to carry more debt, and that using the cash raised to reduce shares outstanding benefits shareholders.

For S&P 500 companies, the proportion of cash to debt on their balance sheets has held steady around 40% since 2003, about double the percentage in the late 1990s, according to S&P data.

Write to Peter A. McKay at peter.mckay@wsj.com2 and Justin Lahart at justin.lahart@wsj.com3

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