On June 14th, International Game Technology (IGT), the world’s largest manufacturer of slot machines, announced a $1 billion share repurchase program, including a $400 million “accelerated” buyback. With IGT stock trading near a three-year low, the announcement had its desired effect: IGT jumped over 14%.
In a share repurchase program – also known as a repo or a buyback – a company uses its cash to purchase, and retire, its own shares. The repurchases are usually done on the open market, though on occasion companies may buy shares directly from investors through tender offers or auctions; or, as in the case of IGT’s accelerated buyback, they may use an investment bank such as Goldman Sachs (GS) to facilitate the transaction. The purpose of a repo is to return capital to shareholders; by buying out shares, existing investors now have a greater claim on the company’s remaining assets. In IGT’s case, the $400 million paid up front should repurchase about 27 million shares, representing about 9 percent of the company’s total shares outstanding. Thus, on a percentage basis, each remaining investor of IGT now owns about 10 percent more of the company than he did previously (for example, a 1% stake in IGT now becomes a 1.1% stake.)
Of course, that larger stake now represents ownership in a company with fewer assets – about $400 million fewer, in IGT’s case. But buybacks improve not only ownership stakes, but earnings per share, a key factor driving stock valuations. In its second quarter earnings report, delivered before the share repurchase was announced, IGT projected fiscal 2012 earnings per share of $0.98-$1.04. The buyback, in and of itself, will boost those per-share numbers; assuming nothing else has changed, IGT’s new guidance range comes out to $1.07-$1.14.
This ability to goose earnings per share is touted as one of the benefits of a share repurchase program; but it is also one of the reasons many investors are skeptical of the programs. Corporate managers, who may receive bonuses based on earnings targets, can use buybacks to increase earnings per share even though net income – the total amount of profits the company is generating – is flat or even decreasing.
In addition, relative to a cash dividend – the most well-known way in which companies return capital to their investors – stock repos show a marked lack of flexibility for investors. Had IGT simply taken the $400 million and distributed it to shareholders in a special dividend, the shareholders could have decided what to do with the money. Many would have re-invested the funds into IGT stock, just as IGT management chose to; but some might have used the proceeds to purchase another stock they felt was more undervalued. A few might have taken the windfall (a small investor with 1,000 shares, or about $15,000 worth, of IGT would receive about $1,100 in our scenario) and gone to Vegas (where they might even have played a few IGT slots.)
A share buyback forces investors, essentially, to purchase additional shares of a stock at a price and time determined by management. And, surprisingly, research has shown that management’s ability to time either the broad market or the price movements of its own shares is not substantially better than that of the average investor. Stocks that execute repurchase arrangements do appear to out-perform stocks that don’t; but the variation is often insignificant, and it’s not entirely clear that the out-performance comes from the buyback. It may be that managers who are implementing buybacks – with the purpose of boosting the company’s share price – are also taking additional steps to increase investor confidence. It may also be that the types of companies that can execute repurchases – generally companies with solid cash balances and the ability to generate more cash on a consistent basis – are better companies in which to invest.
So why do investors accept share buybacks, as opposed to demanding the flexibility accorded by dividends? The answer is simple: taxes. Dividends are currently taxed at a 15 percent rate in the US, though that rate may jump substantially if Barack Obama is re-elected. Dividend tax rates are even higher in the largest European markets (such as France and Germany), and in most of Asia as well. Share repurchase programs avoid these taxes, giving a strong incentive for American shareholders to accept – and even prefer – stock buybacks over dividends as a means of returning capital to shareholders.
Still, dividends remain popular, particularly in the US, given the current zero interest rate environment in the country, and across much of the Western economies. With bank savings account offering interest rates below one percent, and even 30-year US Treasury bonds paying less than 3% annually, gaining income through equities has become a coveted – even required – tactic, particularly for retirees.
Dividend policies break sharply across markets. In the US, constant, steady dividend payments paid quarterly are the norm; companies that can grow their dividend usually do so slowly, aiming for an increase each year. Those companies that do so for a long period of time receive great acclaim in the dividend-stock community; companies that raise a dividend each year for 25 years or more are called “Dividend Aristocrats,” a title bestowed on companies like Coca-Cola (KO), Wal-Mart Stores (WMT), and Johnson & Johnson (JNJ). The slow pace of raises means that dividend cuts for US stocks are usually greeted with a decline in the stock price. IGT itself should be well aware of this fact; it cut its dividend at the bottom of the market in March 2009. Its stock jumped, but only because investors had already bid the price down to a multi-year low, expecting a full elimination of the dividend.
In Europe (and the few dividend-paying stocks in Asia), dividend payments are usually made twice a year, as opposed to the quarterly payments that dominate US stocks. In addition, European dividends are usually far less stable, and far more tied to the company’s performance, rather than its dividend history. For instance, Swedish bookmaker Betsson AB (BETSB.ST), a stock I recommended back in February, publicly announces its dividend policy on its website. Betsson intends to distribute up to 75 percent of annual income to shareholders, “provided that the capital structure can be retained.” This results in a stronger yield – the mid-year pay-out, distributed in June, represented nearly 5% of the stock price – but less certainty. Indeed, Betsson’s dividend decreased from 2010 to 2011, an event that would be greeted with panic on a US market but was expected for the gambling stock, due to the economic weakness in Europe and its pre-announced dividend policy.
These trends are hardly set in stone; many European companies, particularly mega-cap stocks attempting to lure US investors, have moved toward a more American-style regime of steady, quarterly dividend payments. In the US, Wynn Resorts (WYNN) has adopted a more European-style policy, combining small quarterly dividends with a large year-end payout ($8 per share in 2010, and $5 per share in 2011).
No matter the policy, dividends are an important way for companies to return capital to the shareholders. But, like share repurchases, they aren’t foolproof. Particularly in the US, high dividend yields can be signs that the market simply doesn’t believe the dividend is sustainable. An example this week came from US grocer SuperValu (SVU), which until Thursday, yielded about 7%. That day, the company reported disastrous earnings and eliminated its dividend. In a day, the stock lost half of its value, as what seemed to be a cash cow for investors seeking income became a company whose very survival was being questioned.
In addition, individual investors often fail to realize that dividends are subtracted from the stock price. On the day after stock holders officially receive their right to a dividend (known as the record date), a stock will drop by the amount of the dividend paid. Unlike a bond – where interest payments are made and principal is returned in full – dividends are actually just a return of an investor’s capital. That capital, formerly held by the company, is now given back to the investor. Dividend stocks do historically outperform non-dividend paying stocks, but, as with buybacks, the question is one of correlation; does the dividend itself make stocks more successful, or do the types of companies that pay strong dividends – successful, established, profitable firms – outperform the rest of the market?
In short, both dividends and share buybacks are essential tools for companies to reward their shareholders; as such, investors must understand how they work. But they also must be aware that neither buybacks nor cash payouts are ‘free money’; and neither is without risk. This brings us back to IGT and its 14 percent jump on the announcement of its own buyout. CNNMoney contributor Paul La Monica called the move “the stupid stock move of the day,” and I’m somewhat inclined to agree. IGT’s buyback, executed when the stock price was clearly trading below management’s expectations, seems to be a sensible move. It sends a signal to the market that IGT executives are confident in the company’s ability to execute going forward. It also removes some capital that the company might have blown on over-priced acquisitions like its half-billion purchase of Double Down Interactive.
But IGT is still struggling, and the 14 percent jump seems like a stretch. Rival Bally Technologies (BYI) continues to gain market share; its stock has sharply out-performed IGT’s over the past five years. IGT’s earnings are under pressure as well; earnings per share fell from $1.47 in 2007 to $0.94 in fiscal 2011. The company’s net income fall is actually steeper – well over 40% – as IGT reduced its share count by some 32 million shares over that time period, using buybacks like the one announced last month to boost near-term earnings per share.
The bulk of the repurchases came in fiscal 2008, the last time IGT embarked on a major buyback. That year, IGT repurchased 25.5 million shares. The total cost? $779.7 million, an average price of more than $30 per share: almost exactly double IGT’s close of $15.31 on Friday. In 2009, when IGT plunged along with the broad market, hitting a six-year low, the company did not repurchase a single share. Indeed, investors should retain a degree of skepticism toward share buybacks, and no company better illustrates the need for skepticism than IGT itself.