You’ve surely seen all the press about companies spending much of their savings from the 2017 Tax Cuts and Jobs Act on stock buybacks. See, for example, this article. And this article reports on a JP Morgan prediction for this year of over $800 billion in stock buybacks. According to this article in CFO.com, S&P 500 firms repurchased $166.3 billion worth of shares just during the first quarter of 2018, up 18.7% from a year ago. A common rationale for conducting a stock buyback is that the shares are undervalued—thus signaling optimism about the company’s future. In addition, buybacks are often viewed as a useful way to provide shareholders with a cash distribution or to offset dilution. However, in some cases, the author of this study contends, the real motivation may be more opportunistic—managing EPS and increasing executive compensation, regardless of the operational success of the company, where EPS is a performance measure. Comp committees: take note.
The study author examined 293 accelerated share repurchase (ASR) transactions initiated during the period from 2004 to 2011. An ASR, sometimes referred to as an “overnight share repurchase,” is a popular technique for conducting stock buybacks that can give EPS a quick booster shot. In these transactions, the company enters into a transaction with an investment bank for repurchase of a number of shares. In exchange for payment, the bank then delivers to the company a large block of its shares that were borrowed from institutional investors such as mutual funds. The repurchased shares are recorded as the company’s treasury stock, immediately reducing the company’s outstanding share count. The bank then conducts a series of regular open-market purchases over time (typically around five months) to replace the borrowed shares. But it doesn’t matter to the company how long the bank takes to complete the purchases because, from the company’s perspective, the deal is done and reflected on its books. Had the company conducted the buyback through a broker, the limitations of the Rule 10b-18 safe harbor would typically have imposed a much slower time frame.
The study found that, on average, the companies that engaged in these transactions reported improved operating performance during the post-ASR period. But that wasn’t universally the case: in some cases, the author suggests, the companies may have used the ASRs for EPS management. According to the study, approximately 29% of the companies examined were “EPS-suspect,” that is, the companies met or beat analysts’ consensus EPS forecasts within a tight range (i.e., 0 to 5 cents), but would have missed the analysts’ EPS targets had they not conducted the buybacks. (By comparison, only 14% of the companies that conducted regular open-market buybacks during the same time period were EPS-suspect.) Supporting the view that EPS management was a prime motivation, the author argues, the data showed that the proportion of companies that provided their CEOs with EPS-contingent bonuses was greater among EPS-suspect companies than among non-EPS-suspect companies, as was the proportion of “habitual EPS beaters…. As predicted, these results imply that meeting EPS targets is a more important concern for EPS-suspect firms than non-EPS-suspect firms. In addition, the mean book-to-market ratio of EPS-suspect firms is lower than that of non-EPS suspect firms, suggesting that equity undervaluation is less of a concern for EPS-suspect firms.” Moreover, EPS-suspect companies did not report improved operating performance following the ASR announcement, compared with the control group, which did realize significant positive operating performance during the post-ASR period. With regard to the reactions of investors, the study showed that, after controlling for other relevant factors, for EPS-suspect companies, stock returns following the ASR announcement were, “on average, 2.1 percentage points lower than that for …control ASR firms…. These results suggest that investors are not fooled by firms’ attempts to use ASRs to meet or beat consensus forecasts.”
The study author observes that “[i]nterestingly, in only three out of 293 cases, [did] compensation committees report taking into account the EPS impact of an ASR when deciding whether EPS targets [were] achieved. Thus, while using ASRs does not seem to help firms generate a positive investor reaction at earnings announcements, it likely helps some managers secure their bonuses and increase their compensation…and maintain their reputations in the executive labor market.” The study concluded that, while ASRs can be useful tools to signal confidence regarding future prospects, the “research suggests that ASRs are indeed open to abuse and used opportunistically by some managers to quickly boost EPS.” Accordingly, companies that want to “signal better future performance to the stock market should carefully consider the timing of an ASR transaction…. Further, corporate boards need to be cognizant of managers’ incentives related to ASR,” particularly in the context of policies related to repurchases and executive compensation.
