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.”
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.
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.
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.
A major donor to President Trump agreed to pay $10 million to the president’s then-personal attorney if he successfully helped obtain funding for a nuclear-power project, including a $5 billion loan from the U.S. government, according to people familiar with the matter.
The donor, Franklin L. Haney, gave the contract to Trump attorney Michael Cohen in early April to assist his efforts to complete a pair of unfinished nuclear reactors in Alabama, known as the Bellefonte Nuclear Power Plant, these people said.
.. Authorities are investigating whether Mr. Cohen engaged in unregistered lobbying in connection with his consulting work for corporate clients
.. Mr. Cohen made several calls to officials at the Energy Department in the spring to inquire about the loan guarantee process, including what could be done to speed it up
.. James Thurber, a professor of government at American University, said success fees are “outside the ethical norms” among Washington lobbyists and are frowned upon.
Century-old court rulings deemed fees contingent on lobbyists obtaining public funds or killing legislation unenforceable and counter to public policy, saying they encouraged corruption, he said. Several lobbyists contacted by the Journal said $10 million was an unheard-of sum to pay a consultant for government-related work.
.. Mr. Cohen’s other consulting clients, including AT&T Inc. and Novartis AG , the Journal has previously reported, citing people familiar with the matter. Those companies said they paid Mr. Cohen a total of $1.8 million since Mr. Trump took office for his insights into the administration. Both have said he didn’t do any substantial work for them.
Complex societies collapse because, when some stress comes, those societies have become too inflexible to respond. In retrospect, this can seem mystifying. Why didn’t these societies just re-tool in less complex ways? The answer Tainter gives is the simplest one: When societies fail to respond to reduced circumstances through orderly downsizing, it isn’t because they don’t want to, it’s because they can’t.
.. In the mid-90s, I got a call from some friends at ATT, asking me to help them research the nascent web-hosting business. They thought ATT’s famous “five 9’s” reliability (services that work 99.999% of the time) would be valuable, but they couldn’t figure out how $20 a month, then the going rate, could cover the costs for good web hosting, much less leave a profit.
I started describing the web hosting I’d used, including the process of developing web sites locally, uploading them to the server, and then checking to see if anything had broken.
“But if you don’t have a staging server, you’d be changing things on the live site!” They explained this to me in the tone you’d use to explain to a small child why you don’t want to drink bleach. “Oh yeah, it was horrible”, I said. “Sometimes the servers would crash, and we’d just have to re-boot and start from scratch.” There was a long silence on the other end, the silence peculiar to conference calls when an entire group stops to think.
The ATT guys had correctly understood that the income from $20-a-month customers wouldn’t pay for good web hosting. What they hadn’t understood, were in fact professionally incapable of understanding, was that the industry solution, circa 1996, was to offer hosting that wasn’t very good.
This, for the ATT guys, wasn’t depressing so much as confusing. We finished up the call, and it was polite enough, but it was perfectly clear that there wasn’t going to be a consulting gig out of it, because it wasn’t a market they could get into, not because they didn’t want to, but because they couldn’t.
.. The web hosting business, because it followed the “Simplicity first, quality later” model, didn’t just present a new market, it required new cultural imperatives.
.. “If you want something to be 10 times cheaper, take out 90% of the materials.” Making media is like that now except, for “materials”, substitute “labor.”
“Web users will have to pay for what they watch and use, or else we will have to stop making content in the costly and complex way we have grown accustomed to making it. And we don’t know how to do that.”
… Bureaucracies temporarily suspend the Second Law of Thermodynamics. In a bureaucracy, it’s easier to make a process more complex than to make it simpler, and easier to create a new burden than kill an old one.
In spring of 2007, the web video comedy In the Motherhood made the move to TV. In the Motherhood started online as a series of short videos, with viewers contributing funny stories from their own lives and voting on their favorites. This tactic generated good ideas at low cost as well as endearing the show to its viewers; the show’s tag line was “By Moms, For Moms, About Moms.”
.. Once the show moved to television, the Writers Guild of America got involved. They were OK with For and About Moms, but By Moms violated Guild rules. The producers tried to negotiate, to no avail, so the idea of audience engagement was canned
.. The most watched minute of video made in the last five years shows baby Charlie biting his brother’s finger. (Twice!) That minute has been watched by more people than the viewership of American Idol, Dancing With The Stars, and the Superbowl combined. (174 million views and counting.)
.. “Charlie Bit My Finger” was made by amateurs, in one take, with a lousy camera. No professionals were involved in selecting or editing or distributing it. Not one dime changed hands anywhere between creator, host, and viewers.
.. it is the people who figure out how to work simply in the present, rather than the people who mastered the complexities of the past, who get to say what happens in the future.
Two decades ago, the US intelligence community worked closely with Silicon Valley in an effort to track citizens in cyberspace. And Google is at the heart of that origin story. Some of the research that led to Google’s ambitious creation was funded and coordinated by a research group established by the intelligence community to find ways to track individuals and groups online.
The intelligence community hoped that the nation’s leading computer scientists could take non-classified information and user data, combine it with what would become known as the internet, and begin to create for-profit, commercial enterprises to suit the needs of both the intelligence community and the public. They hoped to direct the supercomputing revolution from the start in order to make sense of what millions of human beings did inside this digital information network. That collaboration has made a comprehensive public-private mass surveillance state possible today.
.. It is a somewhat different creation story than the one the public has heard, and explains what Google cofounders Sergey Brin and Larry Page set out to build, and why.
.. The intelligence community wanted to shape Silicon Valley’s supercomputing efforts at their inception so they would be useful for both military and homeland security purposes. Could this supercomputing network, which would become capable of storing terabytes of information, make intelligent sense of the digital trail that human beings leave behind?
.. the Central Intelligence Agency (CIA) and the National Security Agency (NSA) had come to realize that their future was likely to be profoundly shaped outside the government. It was at a time when military and intelligence budgets within the Clinton administration were in jeopardy, and the private sector had vast resources at their disposal. If the intelligence community wanted to conduct mass surveillance for national security purposes, it would require cooperation between the government and the emerging supercomputing companies.
.. To do this, they began reaching out to the scientists at American universities
.. There was already a long history of collaboration between America’s best scientists and the intelligence community, from the creation of the atomic bomb and satellite technology to efforts to put a man on the moon.
.. Silicon Valley was no different. By the mid 1990s, the intelligence community was seeding funding to the most promising supercomputing efforts across academia, guiding the creation of efforts to make massive amounts of information useful for both the private sector as well as the intelligence community.
They funded these computer scientists through an unclassified, highly compartmentalized program that was managed for the CIA and the NSA by large military and intelligence contractors. It was called the Massive Digital Data Systems (MDDS) project.
.. MDDS was introduced to several dozen leading computer scientists at Stanford, CalTech, MIT, Carnegie Mellon, Harvard, and others in a white paper that described what the CIA, NSA, DARPA, and other agencies hoped to achieve.
.. the program’s stated aim was to provide more than a dozen grants of several million dollars each to advance this research concept. The grants were to be directed largely through the NSF so that the most promising, successful efforts could be captured as intellectual property and form the basis of companies attracting investments from Silicon Valley.
.. Today, the NSF provides nearly 90% of all federal funding for university-based computer-science research.
.. The research arms of the CIA and NSA hoped that the best computer-science minds in academia could identify what they called “birds of a feather:” Just as geese fly together in large V shapes, or flocks of sparrows make sudden movements together in harmony, they predicted that like-minded groups of humans would move together online.
.. Their research aim was to track digital fingerprints inside the rapidly expanding global information network, which was then known as the World Wide Web. Could an entire world of digital information be organized so that the requests humans made inside such a network be tracked and sorted? Could their queries be linked and ranked in order of importance? Could “birds of a feather” be identified inside this sea of information so that communities and groups could be tracked in an organized way?
.. The primary objective of this grant was “query optimization of very complex queries that are described using the ‘query flocks’ approach.” A second grant—the DARPA-NSF grant most closely associated with Google’s origin—was part of a coordinated effort to build a massive digital library using the internet as its backbone.
.. Human beings and like-minded groups who might pose a threat to national security can be uniquely identified online before they do harm. This explains why the intelligence community found Brin’s and Page’s research efforts so appealing
.. The two intelligence-community managers charged with leading the program met regularly with Brin as his research progressed, and he was an author on several other research papers that resulted from this MDDS grant before he and Page left to form Google.
The grants allowed Brin and Page to do their work and contributed to their breakthroughs in web-page ranking and tracking user queries. Brin didn’t work for the intelligence community—or for anyone else. Google had not yet been incorporated. He was just a Stanford researcher taking advantage of the grant provided by the NSA and CIA through the unclassified MDDS program.
.. The MDDS research effort has never been part of Google’s origin story, even though the principal investigator for the MDDS grant specifically named Google as directly resulting from their research: “Its core technology, which allows it to find pages far more accurately than other search engines, was partially supported by this grant,” he wrote. In a published research paper that includes some of Brin’s pivotal work, the authors also reference the NSF grant that was created by the MDDS program.
NSF likewise only references the digital libraries grant, not the MDDS grant as well, in its own history of Google’s origin.
.. But the grant from the intelligence community’s MDDS program—specifically designed for the breakthrough that Google was built upon—has faded into obscurity.
.. Brin’s breakthrough research on page ranking by tracking user queries and linking them to the many searches conducted—essentially identifying “birds of a feather”—was largely the aim of the intelligence community’s MDDS program. And Google succeeded beyond their wildest dreams.
.. most people still don’t understand the degree to which the intelligence community relies on the world’s biggest science and tech companies for its counter-terrorism and national-security work.
.. in the most recent reporting period between 2016 and 2017, local, state and federal government authorities seeking information related to national security, counter-terrorism or criminal concerns issued more than 260,000 subpoenas, court orders, warrants, and other legal requests to Verizon, more than 250,000 such requests to AT&T, and nearly 24,000 subpoenas, search warrants, or court orders to Google.
.. In this way, the collaboration between the intelligence community and big, commercial science and tech companies has been wildly successful. When national security agencies need to identify and track people and groups, they know where to turn – and do so frequently. That was the goal in the beginning. It has succeeded perhaps more than anyone could have imagined at the time.