Corporate America has fallen in love with its own stock. Companies are buying back their shares at a record pace this year: Through the third quarter, companies that comprise the S&P 500 repurchased about $245 billion of their shares and figure to buy back more than $300 billion for the year, according to Standard & Poor’s. This compares with $197 billion all of last year.

Silverblatt

By comparison, S&P only expects S&P 500 companies to dole out about $200 billion in dividends this year, up from $181 billion last year. “Management is reducing their share count,” says S&P equity market analyst Howard Silverblatt.

Many of these buybacks are substantial. For example, in the September quarter, 93 issuers reduced their shares outstanding by at least 1 percent while over the last four quarters, compared with 81 issuers in the second quarter.

Companies buy back their stocks for essentially two reasons. The first is to reduce their per-share earnings, with the hopes that their stock price will subsequently rise. For example, The S&P study found that 61 issuers reduced their shares outstanding by at least 4 percent over the past four quarters. As a result, approximately 4 percent of earnings growth could theoretically be attributed directly to share reductions at those companies.

The second reason companies buy back their shares is to offset exercises of stock options to avoid dilution of their overall shares. “This is a legitimate use of cash,” says Silverblatt.

Largest Buybacks

According to an anecdotal study run for Compliance Week, most of the largest issuers of stock options indeed are aggressive buyers of their own shares. Compensation analysis firm Equilar put together a list of companies that granted the most options over the past three years, based on both option volume and value. According to Equilar, the 10 companies that granted the most options in the past three years are Cisco Systems, Intel, Sun Microsystems, Bank of America, Time Warner, Pfizer, Microsoft, Motorola, Lucent Technologies, and Hewlett Packard.

Four of those companies also top the list of those offering the most options on a value basis: BofA, Cisco, Intel and Pfizer. The other six companies are eBay, IBM, UnitedHealth Group, Citigroup, Johnson & Johnson and Procter & Gamble.

Many of these largest stock option granters have also established the largest buyback programs; in fact, the largest, at $30 billion, was announced by Microsoft last year.

And while there is no definitive study supporting the direct connection between the largest options granters and those that have the largest buyback programs, benefits experts and lawyers agree with the logic behind it.

Meyers

“Companies that use equity compensation in general engage more heavily in buybacks,” points out Arthur Meyers, partner with Boston-based Edwards Angell Palmer & Dodge who counsels companies on all aspects of employee benefits, adding that he is referring mostly to options. “They must manage the dilution.”

Earlier this year, for example, Intel announced a $25 billion stock buyback plan—the second largest ever. Since the company’s stock buyback program began in 1990, Intel has repurchased about 2.5 billion shares for about $49 billion. For the first three quarters of this year, Intel repurchased over 300 million shares at a cost of about $7.5 billion, compared to $7.5 billion in buybacks for all of 2004, the previous record for a full year.

Procter & Gamble repurchased $5.6 billion of its stock in the third quarter, the most among S&P 500 companies, according to S&P. According to MarketWatch.com, Bank of America, Pfizer and Hewlett-Packard made the list of the 10 companies that have announced the largest buybacks this year, along with Intel.

And in 2004, Cisco announced that its board authorized up to $5 billion in additional stock buybacks, bringing its stock buyback program to $25 billion since the beginning of the decade.

Repurchases And M&A

Silverblatt at S&P tells Compliance Week that he has also noticed a relatively new—but likely growing—phenomenon, whereby companies that complete large buybacks subsequently use the repurchased shares to buy another company.

For example, when Procter & Gamble agreed in January to buy Gillette for about $55 billion, P&G also announced plans to repurchase between $18 billion and $22 billion of stock within 12 to 18 months.

In September, Oracle agreed to buy Siebel Systems for approximately $5.9 billion (net of Siebel's cash on hand). Under the deal, Siebel shareholders could elect to receive either cash or stock; in making the announcement, Oracle said it intends to repurchase an amount of shares equal to the number of shares issued in the transaction.

Back in late 1999, Exxon completed its merger with Mobil for $81 billion in stock and assumed debt. Since then, ExxonMobil has reduced its shares in 20 of 21 quarters, according to Silverblatt. Other companies, such as General Electric, also have a history of repurchasing stock that is later utilized for mergers and acquisitions, says Silverblatt. “I expect to see more of it in the future,” he adds. “Buybacks are just beginning.”

Why would companies go through the trouble of shelling out cash to repurchase shares that are then issued to an acquired company, instead of simply holding onto the cash for use in acquisitions?

Silverblatt says there are several reasons. First of all, it buys time for a company loaded with cash as they hunt for strategic acquisitions. Second, it immediately increases the company's EPS. Third, it answers incessant shareholder questions about what the company plans to do with its cash. And finally, the stock can typically be utilized for acquisitions with ease; and shareholders at acquired entities usually like to receive stock for tax purposes. There's also little risk, unless the value of the company's stock deteriorates. “The risk is if the stock then goes down, it is worth less,” says Silverblatt.

Governance Implications

You'd expect that the buyback-for-acquisition strategy would trouble corporate governance advocates, but it doesn't. “It’s a little cockeyed way about going about it,” says Paul Hodgson, a senior research analyst and compensation expert with The Corporate Library. “But it’s probably not going to cause stockholders much concern.”

In fact, what could cause shareholders more concern is if their company doesn’t have a policy of buying back their shares. According to a recent exhaustive study by Sudhir Nanda at T. Rowe Price, firms that decrease shares outstanding outperform those that increase shares outstanding.

The money manager studied the 3,200 largest U.S. stocks from December 1980 to October 2004, measuring the change in shares outstanding over a 12-month period and the share price return in the subsequent 12-month period. The result: The 10 percent of companies that had the greatest decrease in shares outstanding enjoyed the best stock price performance—a 19 percent increase.

The 10 percent of companies with the largest increase in shares outstanding on average showed the worst stock price performance, down 5 percent. The difference in performance—14 percentage points in the first year—continued to expand through the second year, by another 9 percentage points.

Athey

“Shrinkers do better than issuers of stock,” asserts Preston Athey, portfolio manager for the T. Rowe Price Small Cap Value Fund. “Seventeen percentage points compounded over 20 years is an enormous number. A lot of CEOs and boards don’t get it,” noting that CEOs of many firms prefer to simply become bigger.

The performance effect occurred in both up and down markets, and was seen in 88 percent of the observed periods.

The conclusion of T. Rowe Price report: Absent other factors, stock buybacks are demonstrably good for shareholders, Price points out in its report.