BP Stock Buyback – a missed opportunity, and why buybacks distort capitalism.

BP will use some of its windfall Ukraine Oil Spike profits to fund a stock buy-back. Stock buy-backs are appropriate is some limited circumstances, but generally they distort the way capitalism is supposed to work, undermining good companies and sound corporate governance.

Blain’s Morning Porridge, August 4th 2022 – BP Stock Buyback – a missed opportunity, and why buybacks distort capitalism.

“Greed is Good… ” (actually… it’s not..)

This morning: BP will use some of its windfall Ukraine Oil Spike profits to fund a stock buy-back. Stock buy-backs are appropriate is some limited circumstances, but generally they distort the way capitalism is supposed to work, undermining good companies and sound corporate governance.

Over the past few days there has been a screed of comment about the enormous profits being made by Oil Producers. Furious consumers, hostile reporters and politicians are milking the consensus it’s immoral for oil companies to profit from the oil spike in time of crisis. Range Rover drivers are taking out mortgages to buy diesel (I know!) Desperately broke workers are scratching together whatever pennies they can find to fill their tanks so they can get to work to earn enough to fill the tank, to enable them to get to work so they can afford to fill the tank to let them get to work… etc… etc..

That’s the way markets work.

However, BP is going to use a significant slice of its $8.5 bln second quarter profits to buy-back its own equity from the market. Its allocated $3.5 bln for a stock buy-back programme.

I am not a fan of buy-backs. There is a time and a place when buy-backs might be appropriate – but they are very limited. Here’s a question for a PhD doctorial candidate to answer: Do companies which execute large stock buy-back programmes exhibit stronger or weaker long-term performance and results?

I suspect not.

BP’s management have taken the view their stock is undervalued by the market (remember, Greta Thurnberg still hates them as does every single 25 year old ESG analyst), and that the best way for Ukraine windfall profits to be put in the pocket of its owners, the investors, (which include just about every single UK pension saver), is via a buy-back. There is logic in that.

Personally, I like the way Shell and BP are diversifying away from oil and into renewables. But, I think BP should have announced a more imaginative plan to diversity away from its announced $18 bln long-term strategy of more mega-wind farms, and targeted the $3.5 bln on tidal energy development in the UK. (Tide would make far more sense – utterly reliable power for ever.. whereas… Windfarms are a lesson we’re going to regret.)

Otherwise, at its most basic a company mounting a buy-back has made a “rational” economic decision that there is nothing better it can find to do with its cash. It has concluded the best thing it can do with cash is not to:

  1. Invest it in the bank
  2. Invest it in new productive capacity
  3. Invest it in creating new jobs
  4. Invest it in buying other companies
  5. Invest it in the employees through better pay and benefits

Instead, a buy-back gives the cash back to its’ owners, the stock holders, by offering to buy back their stock. Buying back stock boosts demand for the shares, and reduces the number of shares in circulation, thus pushing up their value as fixed demand exceeds limited supply . Of course, the company could also pay a larger dividend to its owners – but that would raise an income tax liability for investors.

Earlier this week Apple borrowed $5.5 bln from the bond market. It is expected to use that cash to fund its current stock buyback programme, which has already purchased $90 bln of Apple Stock this year!  Yet Apple is already sitting on a cash pile of $180 bln dollars – making it a major investor in its own right.

Apple has reached a “rational” economic decision that paying 150 basis points more than Treasuries, around 4.75% for 10-year money, to borrow money to buy back stock is more efficient and better for the company’s bottom line than eating into the cash pile, which can earn a higher invested return (maybe). They are confident the high margins they earn by paying Asian works to slot together their products can more than cover the cost of the debt. It’s a classic economic win for Apple.

Apple is one of the few triple Aaa rated corporate credits, so they aren’t worried that increased leverage (borrowing more) will affect their Experian credit score. In effect Apple is raising debt to retire equity, condensing the ownership of the company into fewer shares – pushing up their value, and it makes sense… of a sorts..

What happens when the management of a company spend more time worrying about the economic efficiencies of their buy-back programmes, rather than customer service, products, innovation, competition, or critically, how they retain and develop their staff?

Buying back shares can have some significant benefits. As the number of shares in circulation falls, the Earnings Per Share (EPS) will rise – making the company look stronger! Generally, however, buyback distort the way a company operates.

Cutting out the b*llsh*t and mumbo-jumbo about economic efficiency, the real purpose of any stock buyback programme is simpleto boost the stock price by creating a bid for the stock! Higher stock prices make the management look good.

As the most valuable company on the planet, Apple’s stock is certainly not undervalued – but the company is happy to manipulate that price higher via its ongoing buyback programme.

The questions are:

  • What would happen if/when someone produces a better iPhone and better bright shinny things?
  • What would happen if/when Apple is no longer the number one consumer tech firm?
  • What would happen if Apple’s stock price started underperforming?
  • How long would that $180 bln of retained profits in the cash pile be available to boost the stock price? (Just over a year at the current stock buyback burn-rate.)
  • What would happen if falling profits meant Apple’s easy access to the bond market for funds – its liquidity – was to suddenly close?

Shock, horror… surely I am not suggesting the reason Apple’s stock price is so high is because Apple has the ability to keep it high? Perish the thought… (US Readers: raised eyebrow, wink-wink moment..) Research has shown that companies with large cash-piles tend to have stronger stock market valuations – but a large war-chest gives a firm more options.

If things did go wrong, Apple could claim that its massive buy-back programme means its’ done its duty to shareholders by buying back the stock to put cash in their hands. The company would be worth far less, and would still have the problem of repaying the debt it had raised to pay for buybacks. Ouch. That is a very real problem for the very many US Public corporates and Private Equity Junk bond issuers which used the ultra-low rates of the 2010-2022 ZIRP Central Bank era to raise gazillions of dollars at next-to-zero interest rates.

But Apple is a relatively benign example of why Stock Buybacks are generally a bad thing..

The worst example of buy-back distortion, and probably the worst company on the Planet today, is Boeing.

I have told this story many times, but here’s the abridged version:

Boeing was the best company on the planet. It made wonderful planes. Its engineers were the best. Boeing made billions from its B-737 programme.

As the original regional jet got old and relatively 0less efficient, they had a choice. They could invest billions in a wholly new plane design to create a new hyper-fuel-efficient plane, or they could stretch the existing plane just a little bit more. In the old days, engineering led Boeing would not have hesitated. But the engineers no longer ran the firm – accountants did.

They did the economics and ran the numbers. They realised their stock options were the critical factor – not shareholders, workers or customers. They realised they would get massive stock bonuses if the stock price rose – so rather than invest in a new plane, they built the B-737 Max, borrowed more and added it to the stock buy-back programme, and successfully pushed up the stock value. They did not build better planes.

The execs got very very wealthy. They pushed workers harder and harder to deliver cost savings. Workers got paid less and got very unhappy. The B-737 Max was a badly designed death trap killing 247 people. No one has gone to jail. Yet. The company has scaled back deliveries of B-787 Dreamliners because build quality is so poor.

Today Boeing is neutered. The build quality on its planes is awful. It does not have a single modern plane any airline really wants to buy. It does not have the cash to invest in a new design. The public don’t trust its products. If it wasn’t for its role within the US military-industrial complex – it would have been shut.

No time for five things..

Out of time and back to the Day Job!

Bill Blain

Strategist – Shard Capital

11 Comments

  1. Well you did ask what the PhDs would say re buybacks!… Most empirical studies show small or slightly positive impacts on long term performance see e.g. https://www.bis.org/publ/qtrpdf/r_qt2009d.htm
    But also I think the argument that buybacks mechanically increase share price and EPS is a bit iffy. Yes, if companies could secretly create demand for their shares then other investors might misconstrue the flow as indicating someone knows something they don’t, and might want to jump on the bandwagon. But there is no secret…they tell everyone they are doing it. In many cases they are revealing that they have excess cash which they will not be putting to use (or even just earning interest on), and this would – other things equal – probably lead me to revise down future earnings accordingly. Hence no impact. Or in other cases they are rebalancing between equity to debt (especially if borrowing to fund the repurchase like Apple). Does higher leverage support a higher share price? Depends. I suspect the reason the empirical evidence is mixed is because although in each buyback yes there is a fall in the number of shares (the denominator of EPS), but investors will also revise expected earnings (the numerator) up or down depending on how they assess the rationale for each buyback. Asness’s articles are fun on this topic https://www.aqr.com/Insights/Research/Journal-Article/Buyback-Derangement-Syndrome

  2. It is often said that a reason for share buy-backs with the consequent increase in EPS and share price is to benefit executives on bonuses determined by these parameters. True or false?

  3. If it’s the case that companies buyback their own shares instead of paying dividends to protect owners from income tax liabilities, why don’t governments tax buybacks?

  4. Isn’t most of the $180B Apple cash essentially stuck in Ireland and/or other domiciles around the world? I think they’re forced to sit on it or have to repatriate and pay significant taxes on it before they could use that for buybacks. Not to take away anything from your point on buybacks generally though -I’ll personally take my tax inefficient dividends any day so I can reallocated to my favorite idea and because I generally don’t trust management to time the buy backs well. I always enjoy reading BMP & thanks for all the hard work!

  5. A friend who actually teaches engineering observes:

    “I have an alumna working for Boeing. We spoke regularly her first few years after graduating from Virginia Tech and she desperately regretted her decision. She is a young black female working at a Boeing facility in the Los Angeles area, which is controlled by old, white men.

    She had to spend time at a Boeing office in Mississippi which was controlled by old, racist, white men. Black engineers would periodically find small nooses on their desks. Then came the two Max crashes.

    I told her to get out, pronto. Her resume, though still newish, was strong with summer internships (at Boeing in the Midwest) and good enough. I have not heard from her in two years.

    Awful, awful, stale, moribund legacy company, many of which have been killed by greedy executives more concerned with short term share prices and the cash in their options. GE, Intel, HP, the list goes on.”

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