More than Half of All Stock Buybacks are Now Financed by Debt. Here’s Why That’s a Problem

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.”

The Last Chance to Defeat China and Win Back the Cyber Domain?

Two months ago, when Zooming In did a story on Huawei and global 5G deployment, Huawei was poised to take control of much of the world’s cyber domain. We talked about the national security implications of that prospect. And we observed the U.S. efforts to raise awareness of that risk. Two months later, when we did another story on this topic, we realized the world knows Huawei a lot better through these efforts, but Huawei’s momentum has not stopped. In fact, Huawei and China are playing a grander game. They have a brilliant strategy that is working well with the very nature of a crony capitalism. Can this battle still be won by the free world? And what does it take to win? Let’s find out in this edition of Zooming In.
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Letting the Internet Regulate Itself Was a Good Idea — in the 1990s

Tech regulation may be the only thing on which a polarized Capitol Hill can agree. “We should be suing Google and Facebook and all that, and perhaps we will,” President Trump recently declared.Senator Elizabeth Warren, a Democratic presidential candidate, has made the breakup of tech companies a central plank of her campaign. Even Silicon Valley-friendly contenders like Pete Buttigieg have called for curbs on the industry’s power.

If Americans buy into the idea that the tech industry is an entrepreneurial, free-market miracle in which government played little part, then the prospect of stricter regulation is ominous. But that isn’t what actually happened. Throughout the history of the tech industry in the United States, the government has been an important regulator, funder and partner. Public policies — including antitrust enforcement, data privacy regulation and rules governing online content — helped make the industry into the innovative juggernaut that it is today. In recent years, lawmakers pulled back from this role. As they return to it, the history of American tech delivers some important lessons.

Advocates of big-tech breakup often point to precedent set by the antitrust cases of the twentieth century. The three biggest were Microsoft in the 1990s, IBM in the 1950s through the 1980s, and the moves that turned AT&T into a regulated monopoly in 1913 and ended with its breakup seven decades later. Microsoft and IBM didn’t break up, and even AT&T’s dissolution happened partly because the company wanted the freedom to enter new markets.

What made these cases a boon to tech innovation was not the breaking up — which is hard to do — but the consent decrees resulting from antitrust action. Even without forcing companies to split into pieces, antitrust enforcement opened up space for market competition and new growth. Consent decrees in the mid-1950s required both IBM and AT&T to license key technologies for free or nearly free. These included the transistor technology foundational to the growth of the microchip industry: We would have no silicon in Silicon Valley without it. Microsoft dominated the 1990s software world so thoroughly that its rivals dubbed it “the Death Star.” After the lawsuit, it entered the new century constrained and cautious, giving more room for new platforms to gain a foothold.

The U.S. Wants to Ban Huawei. But in Some Places, AT&T Relies On It.

U.S. officials have told telecommunications executives around the world to steer clear of Huawei Technologies Co., calling the company a national-security threat, but that hasn’t prevented AT&T Inc. T 0.72%from using the Chinese company’s equipment in Mexico.

While AT&T has kept Chinese equipment out of its domestic networks, industry executives say the U.S. company uses Huawei’s gear to run a large part of the wireless network in Mexico, where the electronics giant is as welcome as any other supplier.

Huawei boxes sit atop cellphone towers across Mexico, where AT&T is the No. 3 provider in terms of wireless subscribers. The Dallas company inherited much of its Mexican gear through acquisitions, though executives say it also has used the Chinese supplier to upgrade its 4G network in recent years.

“We are the most significant vendor in this country,” Cesar Funes, a Huawei vice president in Mexico, said in an interview. “We respect, of course, headquarters’ discussions with their governments. We just continue supplying them what we are asked to supply.”

“When we upgraded our Mexico network to 4G LTE, we replaced Huawei in our data core network with equipment from the same suppliers we use in the United States, because it gave us consistency in design and scale in purchasing,” the spokesman said. “We expect to harmonize our networks in the same way when we upgrade to 5G in Mexico.”

Huawei competes with Sweden’s Ericsson AB and Nokia Corp. of Finland to equip cellphone network operators. Most large telecom companies keep two or more suppliers in the mix to maintain leverage in future negotiations.

.. Huawei is the world’s top telecom supplier, according to market analyst Dell’Oro Group. Its success abroad has alarmed American officials who fear that telecom executives won’t be able to avoid using Chinese producers, especially in countries with close economic ties to the U.S.

Today’s 4G networks are linked across borders, but future 5G networks could make national boundaries even less relevant. Mr. Strayer said newer cell-tower equipment will be more than “dumb” conduits for information, leaving a broader swath of cellphone networks vulnerable to potential snooping.

AT&T entered Mexico in late 2014 after the Mexican government enacted legislation to enhance competition in a famously concentrated telecom market. The Dallas company pieced together a wireless company by snapping up two smaller players, Iusacell and Nextel Mexico, inheriting a dense network of machinery bought from Huawei, among other suppliers.

.. AT&T doubled down on Huawei over the next four years as it upgraded the infrastructure it acquired to support 4G service. A senior AT&T executive in 2016 told an industry publication that the supplier’s performance was “excellent.” The company has estimated the price of replacing the Huawei electronics it has in Mexico and found the cost prohibitive, according to a person familiar with the matter.

.. The Chinese company, which also makes cellphones, has spent years raising its profile in Mexico. It had its brand name splashed across jerseys for the popular soccer team Club América—until the AT&T logo took its place. When AT&T’s Mexican headquarters moved into a glassy tower finished in 2016, Huawei moved into a satellite office a floor away to stay close to its client.
.. AT&T has bet that a Mexican middle class can boost its future profits. The company invested more than $7 billion, including the $4.4 billion spent to acquire Nextel and Iusacell, over the past four years to improve its network there.