The era of cheap borrowing is fostering corporate America’s favorite investor-pleasing activity: Share buybacks.
Indeed, more than half of all buybacks are now funded by debt. And while there’s an argument that repurchases benefit share prices and investors, at least in the short run, it’s questionable whether highly indebted companies should be doing this. Sort of like mortaging your house to the hilt, then using it to throw a lavish party.
Borrowing oodles of money to buy back shares at the end of an economic cycle, when share prices are near record highs, may seem especially dubious for highly indebted companies like AT&T and American Airlines. Buybacks per se are not inherently wrong-headed, wrote RIA Advisors Chief Investment Strategist Lance Roberts on the Seeking Alpha site, but “when they are coupled with accounting gimmicks and massive levels of debt to fund them … they become problematic.”
Lower interest rates have been a big catalyst for buybacks for years, and further rate reductions can only fuel companies’ urge to gather in even more shares. The Federal Reserve last month decreased its benchmark for short-term rates by a quarter percentage point, and futures markets expect at least two more reductions in 2019. The 10-year U.S. Treasury note, which calls the tune for long-term corporate bonds, yields 1.59% annually, half of what it was last November.
Disturbingly, companies are channeling more cash to investors than they are producing in free cash flow, the first time that has occurred since the Great Recession, according to Goldman Sachs. “Unless earnings growth accelerates materially, companies will likely continue to fund spending by drawing down cash balances and increasing leverage,” wrote David Kostin, Goldman’s chief U.S. strategist, in a note to clients.
Buybacks are a strong catalyst for the bull market. In fact, they are a more significant factor than economic growth, a study last year in the Financial Analysts Journal concluded. The research covered 43 nations over two decades.
Buybacks last year hit a record in the U.S., reaching $806.4 billion for the S&P 500, besting the previous high point of $589.1 billion in 2007, according to S&P Dow Jones Indices. Goldman expects them to finish near $1 trillion in 2019. In this year’s first quarter, S&P 500 companies, which cover 80% of U.S. market valuation, bought back $205.1 billion, up 8.8% from the comparable period in 2018.
With fewer of a company’s shares available, the all-important metric of earnings per share swells—to the delight of investors. They’re also happy to receive a bunch of cash for their shares. Plus, a higher EPS, even if artificially enhanced via a buyback, often guides executive compensation.
Why debt dominates
In 2018, according to Yardeni Research, borrowing funded 56% of that year’s record buybacks. Existing corporate cash on the books, of which there is an abundance, is used less often.
Why is this? Ultra-low borrowing costs mean the interest outlay is relatively minuscule, almost a rounding error. As a result, cash can be stockpiled in case it is suddenly needed. And costs are light even for long-term bonds, whose rates the Fed doesn’t control. We’re talking about the 10-year Treasury note, the benchmark for corporations to fix the rates on their own bonds.
In an indirect way, a lower-rate environment is keeping long rates down. Long rates are so low in Europe and Japan, and often negative, that the 10-year T-note is extremely attractive to foreign investors—as is its haven status amid international turmoil, of course. That elevates the price, in turn pulling down the yield. Bond prices and yields move in opposite directions. U.S. corporate bonds respond by lowering their rates.
Further, American companies’ bonds get a tax break on the interest they pay. Not as good as it used to be, yet not bad either. Before the 2017 tax overhaul, they could deduct 100%, but the reform dropped that to a ceiling of 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization).
And there will be an even bigger need for debt to fund repurchasing programs ahead, as corporations’ enormous cash stashes likely will shrink. That’s because, after romping for a long time, earnings growth appears to be on the wane. Earnings typically feed the cash repository. By FactSet’s count, second-quarter S&P 500 earnings dipped 0.7%.
The repurchase reflex
Buybacks are an arena dominated by major companies, many of them long-established tech titans. The top 20 buybacks accounted for 51.2% of the total for the 12 months ending in March, S&P Dow Jones Indices states.
The all-time champ is Apple, which set a quarterly record for repurchases, laying out $23.8 billion in this year’s January-March period. During the past 10 years, it spent $284.3 billion on buybacks. Over the 12 months through March, other voracious buyers were Oracle ($35.3 billion), Cisco Systems ($22.8 billion), Bank of America ($21.5 billion) and Pfizer ($15 billion).
Okay, they have pretty good balance sheets. But what about companies that are heavily debt-laden? Take AT&T, which thanks to its 2018 acquisition of Time Warner, now called WarnerMedia, piled on a dizzying amount of debt. As of the second quarter, long-term debt stands at $159 billion. Nevertheless, Chief Executive Randall Stephenson said on the July 24 earnings call that “we’ll take a hard look at allocating capital to share buybacks in the back half of the year.”
His justification? The company is busy whittling down its debt, having shrunk it $18 billion in the year’s first half, with $12 billion more expected in the second half. Stephenson says debt should be down to 2.5 times EBITDA by year-end, a level that he believes will allow him to prudently repurchase shares. A company spokesperson added that buybacks benefit all shareholders, including the 90% of U.S. employees who own AT&T stock. Trouble is that, according to Goldman, the telecom giant’s Altman Z-Score, which measures credit riskiness, is right now 1.1—which means it is very risky (above 1.8 is in the safe zone). On the other hand, it still is investment grade, rated BBB by Standard & Poor’s.
The same can’t be said for American Airlines Group, which is a junk-rated BB- and has an Altman Z-Score of just 0.8. But the airline, which is buying 50 new planes, is also in the middle of its latest stock buyback program, having spent $1.1 billion of the $2 billion authorized for repurchases. It disbursed $600 million in this year’s first quarter.
The air carrier’s long-term debt stands at $21.2 billion, and net debt is a daunting 4.5 times EBITDA, by Goldman’s measure. A company spokesperson said the company’s priorities are to pay down debt, invest in the business, and return cash to investors. In late 2018, Chief Financial Officer Derek Kerr said that “our stock is under-valued.” Since February 2018, the share price plummeted, losing half its value. The slump likely stems from the global economic slowdown, the trade war and the grounding of the Boeing 737 MAX, analysts say.
But that’s not stopping American and some others, despite their high leverage, from paying investors for their shares. And other than a recession, which generally keelhauls buyback plans, don’t expect companies to ease off their repurchases.
But once a recession inevitably arrives, the result may not be pretty for companies with lots of leverage, in no small part due to buybacks. With corporate debt now higher than its peak in scary late-2008, Dallas Fed President Robert Kaplan has warned, overly leveraged companies “could amplify the severity of a recession.”