Pay close attention to the cannibals – the businesses that are eating themselves by buying back their stock.
Charlie Munger
Last week, I discussed capital allocation. Each one of the options – raising capital, investing capital, and returning capital – deserves a lot more examination. So, this post will be the first in a series over the next few weeks and I’m going to start with buybacks. Among the various options we examined, returning capital through the use of stock repurchases has recently become one of the most controversial. It is a favorite whipping boy of politicians on both sides of the aisle – Marco Rubio to Elizabeth Warren. They claim that buybacks discourage companies from investing in other more beneficial areas such as wages for employees, research labs, and factories. Buybacks also generate less tax revenue because shareholders get a capital return without having to pay income taxes on the distribution as one would for a dividend. More sinister reasons to dislike buybacks include per-share metrics manipulation by management, artificial strength in near-term stock price (particularly when the C-suite is simultaneously cashing out), and outright value destruction when repurchases are done without regard to valuation.
A buyback done properly should avoid all of the above issues. The political focus on buybacks is all a bit strange because poorly allocating capital for re-investment into the business, dividends or acquisitions can leave companies in the same bad position as a buyback if not more so. Ultimately, good capital allocation is good for all stakeholders. Yet, therein lies the rub. Capital allocation is rarely done right. A buyback should only occur after a company has set aside a rainy day fund and invested in all the high return opportunities available to it to maintain its competitive advantage. A management team that under-invests in its operations in favor of a buyback is risking long-term ruin. For example, take IBM – they pursued a massive buyback for years as they fell behind competitors and revenue stagnated (see chart below). It wasn’t until 2018 that they decided to hit pause and throw a Hail Mary to reinvigorate growth by acquiring Red Hat. Even after including the acquisition, I’d note that trailing 12-month revenues as of today are even lower at $76B!
On the flip side, if after (1) paying all the bills, (2) funding all high IRR projects, and (3) sufficiently fortifying its moat, a company finds itself with extra cash on the balance sheet, they can consider returns to equity shareholders through reducing debt, dividends, or share repurchases. If none of those options makes economic sense at the time, they can just let the cash pile up in the bank until an opportunity presents itself. If, however, management determines that the intrinsic value of the stock is significantly greater than its current market price, a buyback makes a tremendous amount of sense. For instance, if you believe that your stock is worth $100 per share and you can purchase it for $50 in the open market, shareholders get an immediate 100% return on investment for every dollar deployed towards repurchase.
I favor repurchases when two conditions are met: First, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated. We have witnessed many bouts of repurchasing that failed our second test.
Warren buffett
Of course, it’s never been easy for most companies to figure out when their stock is trading at a discount. Or, worse, they have a system for repurchasing stock that is apathetic about valuation; they just buy back X dollars regardless of price. Ugh. Would you pay $200 for groceries that you could buy for $100? Yet, managements have absolutely no problem doing this when repurchasing stock. Human nature seems to encourage us to take the most risk when we can least afford it.
“It is generally the case that most managements, and indeed whole industries, engage in pro-cyclical behaviour. It is greatly dispiriting to see companies repeatedly buying back their shares as the cycle peaks, only to raise fresh capital at the trough. Shareholders invariably lose out in the process.
Marathon Asset Management
OK, we could go on and on discussing buyback philosophy but that wasn’t why I wanted to write this. I wanted to highlight a few companies that have had phenomenal success with their buyback programs. What, if anything, do they have in common? Is there a magic recipe that makes some companies ideal candidates? Let’s take my list of prerequisites for a buyback (bills paid, investments funded, moat widened) and work backwards to create a super-cannibal: The highest value-add buybacks occur when a quality management meets a high margin business with low capital intensity and strong competitive advantages trading at a discount to intrinsic value.
Some examples (charts and tables from ValueLine reports):
DIRECTV
Most are familiar with DIRECTV, the largest satellite TV operator. The buyback at DIRECTV (formerly Hughes, a subsidiary of GM) began in 2004 when NewsCorp was a large shareholder. Then, in 2008, Liberty Media exchanged its stake in NewsCorp for a 41% stake in DIRECTV and the fireworks really started. Looking at our checklist, the company had high operating margins ✔, deceptively low capital intensity (a satellite goes into orbit and then is depreciated over many years but has minimal incremental capex associated with it)✔, and operated in a duopoly with Dish providing exclusive content like Sunday Ticket ✔. It continually traded at a low valuation because the market was always concerned that cable operators would catch up with their HD offerings and subscriber losses were just around the corner. AT&T finally acquired the business in 2015 for $95 in cash and stock. Take note of both the growth in revenues/net profit over the period and the aggressive repurchases that occur during the Great Recession. John Malone was the captain of the ship.
Herbalife
Founded in 1980, Herbalife is a multi-level marketer that has been selling shakes, supplements, and health products for four decades now. It was taken private in 2002 and returned to the public markets in 2004. Since 2006 when shares outstanding peaked at 286 million, the company has been buying back shares opportunistically through thick and thin. Today, shares outstanding are down 52% and heading lower. Gross margins are high at over 80% ✔; capital expenditures are only 2-3% of sales ✔; the social aspects of Herbalife nutrition clubs provide a significant competitive advantage akin to Weight Watchers clubs ✔. Meanwhile, the stock has always traded at a low valuation around concerns that it is a fad or, worse, a pyramid scheme. Carl Icahn has been driving capital allocation since taking a stake in 2013.
AutoZone
The AutoShack was founded in 1979. Concurrent with the acquisitions of AutoPalace, Chief Auto Parts, and TruckPro in 1998, the company’s name was changed to AutoZone. Eddie Lampert and ESL partners had come on board as shareholders and were about to change the capital allocation policy significantly. The number of shares at year end 1998 was ~152 million and as of last quarter there are now less than 24 million shares outstanding (stock price from $20 in 1998 to $1,274 in 2020). Store count has grown from 2,700 to over 6,500. Gross and operating margins are above 50% and 20% respectively ✔; capital expenditures are ~4-5% of sales and new store opening costs and working capital requirements are minimal ✔; an over two decade consolidation of a fragmented industry has led to scale advantages ✔. Despite its performance, the valuation has always been at a discount to the S&P 500 and spent most of the last 20 years with a low teens P/E multiple.. My guess as to why it’s been cheap the whole time is that the market has always been afraid of the leverage being applied to the business; yet, it missed the fact that, unlike most retailers, auto parts are a very stable business and even counter-cyclical. Also, while the person at the helm is very important for a buyback, you still need a good underlying business for it to be successful. As a counter-example, Eddie Lampert made an absolute mess of Sears and K-Mart by signing off on huge repurchases while simultaneously not investing in stores. Same allocator, different result – Chapter 11.
A few more examples (I will leave the analysis of whether and why these businesses are good candidates to you):
| Company (Years) | Shares – Begin | Shares – End | Price low – Start | Price high – End |
|---|---|---|---|---|
| NVR (1993-ongoing) | 17.87 | 3.6 | $5 | $3,525 |
| CarMax (2012-ongoing) | 227 | 163 | $18.60 | 103.20 |
| AutoNation (1998-ongoing) | 458 | 89 | $10 | $53 |
| Microsoft (2004-ongoing) | 10,812 | 7,675 | $24 | $198 |
| Oracle (2011-ongoing) | 5,068 | 3,100 | $25 | $60 |
Most of the stocks we own in our portfolios make opportunistic use of buybacks. And, while no set of rules works every time, I hope you now have a basic framework for thinking about what kinds of companies might generate the best returns from implementing a buyback. In my experience, if you can invest in a company when a buyback catalyst appears – new management, tipping over to excess free cash generation, completion of de-leveraging – good things will generally happen.
If you have examples of buyback excellence that you want to share, please comment. Please contact us with questions, info@micawber.us.
“Invert, always invert” Jacobi said. He knew that it is in the nature of things that many hard problems are best solved when they are addressed backwards.
Charlie Munger