Stock Buybacks and Their Association with Stock Options Exercised in the IT Industry
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David N. Hurtt, Baylor University
Jerry G. Kreuze, Western Michigan University
Sheldon A. Langsam, Western Michigan University
Introduction
Stock buybacks are a
traditional way for corporations to return
excess cash to shareholders without increasing quarterly dividend requirements.
These payments are one-time cash distributions, over and above the normal cash
dividend amounts, with the shares normally repurchased in open market
transactions. The popularity of stock buybacks continues. In fact, in recent
years, share repurchases have returned more cash to shareholders than cash
dividends (Song 2002).
Stock buybacks reduce
a companys financial flexibility by distributing available cash or incurring
debt. This loss of financial flexibility could be disadvantageous to both
current and future shareholders. The reduction in capital from stock buybacks
disaffirms the traditional belief that corporate officers are obsessed with
increasing the size of the firm, as measured by growth in market share,
increase in labor employment, and participation in new lines of business.
Corporate officers believe that this growth signals prestige, provides perks,
and secures future employment. Companies need capital to grow, but share
buyback plans distribute capital out of the firm. Why then do companies
decrease their capital and reduce their financial flexibility with stock
buybacks
Stock
Buybacks and Stock Options Exercised
Although numerous reasons for the popularity of stock buybacks
have been cited, one is to help offset the dilutive effects of generous stock
compensation packages for employees, including stock options and stock
contributions to 401 (k) plans. According to a Credit Suisse First Boston
analysis, stock compensation packages are responsible for three-quarters of the
stock buybacks by Standard & Poors (S&P) firms between 1999 and 2003
(Rapoport 2004). Similarly, the FASB requires companies to disclose the
relationship between stock buybacks and stock payment programs with FASB
Statement No. 123R.
Specifically, on December 16, 2004, the FASB
published Statement No. 123R (revised 2004), Share-Based Payment. That statement
replaces FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees. Statement 123R
mandates a fair-value-based method of accounting for share-based payments.
Statement 123Rs disclosure requirements mandate a description of the entitys
policy, if any, for issuing shares upon share option exercise (or share unit
conversion), including the source of those shares (that is, new shares or
reacquired shares). If as a result of its policy, an entity expects to
repurchase shares in the following annual period, the entity is required to
disclose an estimate of the amount (or range, if more appropriate) of shares to
be repurchased during the period (Statement No. 123R paragraph A240K).
Proponents of expensing stock options have
long argued that corporations end up expending cash repurchasing their shares
to prevent option plans from diluting their stock prices and per-share
earnings. Robert Herz, the FASBs chairman, indicated that the boards intent
was to help investors understand the impact that issuance of stock options and
the related stock buybacks can have on a companys cash flow (Rapoport 2004).
Agreeing, Jack Ciesielski, publisher of the Analysts Accounting Observer, thinks the FASB
wanted to be sure anybody whos concerned about the use of cash, which this is,
will have an idea how much cash is going out the door. (Rapoport 2004).
Relationship
between Stock Buybacks and Stock Options
Companies often
dispute this direct relationship. Intel, for example, spent approximately $4
billion on stock buybacks during 2004 and issued 63.7 million shares to
employees due to the exercise of stock options. To counteract dilution from
these options exercises, $641 million in cash outflows were required. Moreover,
while Intel has repurchased 2.2 billion shares at a cost approximating $42
billion from 1990 to 2004, Intel had as many split-adjusted shares outstanding
in 2004 as it did in 1990. Nevertheless, Intel maintains that there is no
connection between their stock buyback and stock option programs. Chuck Malloy,
Intels communication head, said there is no connection between Intels
stock-buyback and stock-option programs, and that Statement 123Rs new
disclosure rule does not apply to Intel.
Following a similar path, Microsoft Corporation during the three fiscal
years ending in June 2005 spent $18 billion to repurchase 674 million shares.
During this same period, however, it issued 666 million shares for $8 billion,
at a net cash outflow approximating $10 billion, partially to counteract
options exercising.
The
purpose of this study is to determine if there is an association between shares
repurchased and stock options exercised. We selected the eighty S & P
companies listed in the Software and Services, Semiconductors and Semiconductor
Equipment, and Technology Hardware and Equipment industry categories, because
this sector historically has engaged in the largest dollar amount of stock
buybacks.
Prevalence of Stock Buybacks
Regardless of the accounting for stock share plans, corporate
stock buybacks remain popular. During 2005, 1,012 U.S.-based publicly traded
companies declared $456 billion worth of stock repurchase plans. That eclipsed
the $312 billion in buybacks for 728 companies during 2004 (Lazo 2006). Figure
1 presents the S & P 500 non-financial sectors stock buyback activity for
the period 1996 to 2005. Annual buyback activity varied during the period, but
the 2004 and 2005 years are two of the three highest years with buyback
activity of $210 billion and $325 billion respectively versus the average over
the ten-year period of approximately $143 billion. Stefan Selig, an investment
banker and vice-chairman of Banc of America Securities, says that repurchasing
stock is one of the most frequently discussed corporate finance topics in
boardrooms today (Henry 2004).
Reasons for
Stock Buybacks
Numerous reasons for and against stock buybacks have been cited.
Specifically, proponents of stock buybacks argue that buybacks put money into
investors hands in a tax-efficient manner. Buybacks have traditionally been
viewed as an effective means to distribute corporate free cash flow to
investors (Stephens and Weisbach 1998). During the past few years, buybacks, by
outpacing cash dividends, have become the major channel though which cash is
distributed to shareholders in the U.S. equity market (Song 2002).
Companies
with excess cash are reluctant to raise dividends because of the fear of having
investors dissatisfied when dividends return to their historical levels.
Failing to maintain dividend payouts is likely to cause the stock price to
decline by a greater amount than the price gains realized from the increase in
dividends.
Increasing and canceling stock repurchase activity is like dating
and breaking up, while increasing and then lowering cash dividends is like
marriage and divorce, according to Steve Galbraith, Mary Viviano and Qi Zeng,
at Morgan Stanley Dean Witter (Lazo 2001). The 2003 tax act may have changed
the relationship between dividends and repurchases. Prior to the 2003 Tax Act,
dividends were taxed at the same tax rate as ordinary income while capital
gains from stock sales were taxed at the lower capital gains tax rate. The 2003
act equalized the tax rate on dividends and capital gains, but repurchases
still offer tax advantages because shareholders wishing to avoid taxation can
withhold their shares from the market and the cost of the stock sold is
considered in the determination of the capital gain.
Secondly, stock buybacks typically generate a healthy increase in
stock prices. Stock repurchase announcements alone send a positive shock to
the stock price, elevating prices some three to fifteen percent. Certainly some
announcements of repurchases are motivated by a desire for this immediate stock
price reaction. In the two weeks following the October 1987 stock market crash,
firms announced buyback plans totaling $44 billion in an effort to raise stock
prices. Similarly following the September 11th World Trade Center
attack, many corporations announced or accelerated their buyback programs to
stabilize stock prices. More stable stock prices may somewhat insulate managers
from current shareholder complaints. Investor confidence and shareholder
loyalty may also increase with more stable stock prices. The extent to which
management compensation such as bonuses or stock option plans are linked to
stock price movement managers have incentives to maintain stock prices.
Furthermore, reducing the number of shares outstanding through stock buybacks
causes the dollar amount of future cash dividends to be reduced for the
company.
Thirdly, Bagwell and Shoven (1989) argue that firms also may
repurchase stock to alter their leverage ratio. If there is an optional
leverage ratio, stock repurchases may enable firms to achieve it. Moreover,
stock repurchases can help fend off unwanted takeover attempts, especially with
active takeover markets (Bagwell 1991). That is, stock repurchases increase the
acquisition price, making a takeover attempt more costly.
Finally, enhancing earnings per share, without the necessity of
increasing earnings, can be achieved through stock buybacks. Reduced shares
outstanding can improve earnings per share amounts at constant earnings levels.
For example, fourth quarter 2005 earnings per share for S & P companies
posted double-digit gains for the 15th consecutive quartera
record. However, a significant number of those companies bought back shares
throughout 2005, helping to feed those earnings per share gains. HCA, Inc., for
example, indicates that its borrowing will cost an extra 4.6 percent on the
$2.5 billion debt. By reducing shares outstanding, earnings will improve about
$0.50 per share. In his 2005 letter to shareholders of Berkshire Hathaway,
Warren Buffett wrote that the tendency for buybacks to goose EPS, regardless of
company performance, encourages executives paid with stock options to do more
buybacks.
Disadvantages
of Stock Buybacks
Stock buybacks can increase stock prices on
announcement, due to the anticipated reduction in the number of shares
outstanding. For example, when Lincare Holdings, Inc. announced a $250 million
stock buyback in December 2004, its stock price jumped $1.08 per share, or
almost 3 percent. However, these increased stock prices can cause additional
pressure on continued stock returns, as holders of stock options will be
encouraged to exercise their stock options, thereby increasing the number of
shares outstanding. Buybacks simply to offset dilution from options should be
cautiously evaluated, as these buybacks possibly could be harmful, unless you
are the one with the options (Kadlec 2000).
Another possible reason for stock buybacks is that there may no
longer be profitable investment opportunities available to the company. If the
opportunities available to the company have low net present values the company
should not invest its excess cash but instead return it to its shareholders.
Stock buybacks would produce a better return for shareholders than money spent
on internal projects. Additionally, the economic climate may influence
repurchase activity. With strong economic prospects, investors reward companies
that plow cash back into their business; however, in uncertain economic times,
the rewards go to companies returning money to shareholders. One danger of
stock buybacks is that it could signal to investors that the company has few
growth prospects. Buybacks implicitly mean companies are not using cash to
reinvest in the growth of the business, make acquisitions, pay debt or increase
dividends. Exxon Mobil, for example, spent more on stock buybacks in 2005 than
it spent on capital expenditures, exploration, and research and development.
Similarly, Boeing Companys decision to resume its share buyback program met
with criticism from its largest union, the Society of Professional Engineering
Employees in Aerospace, which contends those monies should have been spent
instead on developing replacements for the companys aging line of commercial
airliners. Stock buybacks can be seen as an admission that the company cannot
find anything better to do with shareholders capital, which sends an adverse
signal to the market. David Breman, a veteran investor from Dreman Value
Management in Jersey City, N.J., contends that buybacks are almost a white
flag from corporate executives. He questions why one should invest in such a
company, and what is its long-term growth possibility (Petruno 2005)?
Stock buybacks may be a signal of reduced future earnings levels.
Studies have shown that repurchasing firms, on average, experience a decline in
average return on assets during the three years following the announcement,
with the largest decline occurring among firms announcing the largest share
repurchases (Ok-Rial Song 2002).
Many companies, rather than purchasing shares gradually over
several months in open market purchases to take advantage of market conditions,
are launching tender offers to purchase large blocks of shares. In fact, more
than a dozen companies during 2004 launched tender offers to buy roughly 10
percent to 20 percent of their stock directly from shareholders in a matter of
weeks (Henry 2004). Management flush with cash from high profits frequently
initiate stock buybacks. Unfortunately, stock prices may not be a bargain
during this time, causing companies to overpay for their own stock. For example,
Hewlett-Packard Company paid, on average, $53.60 per share for roughly 119.4
million shares from November 1998 through July 2000. At the end of 2006, the
shares traded at $41.19 per share, a decline of 23 percent in value.
Rather than using stock buybacks to distribute corporate free cash
flow to stockholders, companies, in several instances, purchase stock by
tapping their savings or issuing significant debt. Cisco Systems, Inc. spent
$10 billion on stock buybacks during 2005, using as much as $4 billion of its
$18 billion in cash and investments. In contrast, HCA Inc. in 2004 used
borrowed funds to offer $25 billion for 13 percent of its outstanding stock.
Although its stock price rose 3.3 percent on the announcement, Standard &
Poors and Fitch Ratings downgraded its bonds to junk bond status. Even when a
company does not incur additional debt to buyback shares, some credit-rating
agencies view that as a signal that the company may be more willing to take
financial risks and the credit agencies are certainly aware of the firms
reduced financial flexibility. For example, the price of shares of Knight
Ridder Inc. rose 5.4 percent after an announced buyback plan of 10 million
shares using available cash flows. The move, however, caused Fitch Ratings and
Moodys Investor Service to drop their debt rating, and Standard & Poors
revised outlook for Knight Ridder Inc. decreased from stable to negative.
Association
Between Exercised Options and Stock Buybacks
Many believe that stock buybacks frequently are necessitated by
employee stock option plans. In fact, in a June 2004 report, Credit Suisse
First Boston accounting analyst David Zorn estimated that 77 percent of the
share repurchases by Standard & Poors 500 companies from 1999 to 2003 were
to offset dilution from options exercised (Rapoport 2004). Similarly, Professor
Christine Jolls argues that half of all stock repurchases in the United States
are done to avoid reducing managerial compensation (Ok-Rial Song 2002). Marc
Siegel (2006) argues that, in a majority of cases, stock repurchases are
because of stock-option activity. Under stock-option-based compensation
systems, managers are encouraged to choose repurchases over dividends to
distribute excess cash, given that the value of stock options is negatively
correlated to dividends. Moreover, stock buybacks can boost share prices,
further encouraging current and former employees to exercise their options.
Dittmar (2000) contends that firms which compensate their executives with a
large number of stock options may find it beneficial to repurchase stock.
Company
Practices Related to Stock Buybacks and Stock Options
To investigate the association between shares repurchased and
stock options exercised, we selected the eighty S & P companies listed in
the Software and Services, Semiconductors and Semiconductor Equipment, and
Technology Hardware and Equipment industry categories from the April 4, 2005
edition of Business Week. These industry categories were selected for several
reasons: Analysis performed by Annex Research of S & P companies indicated
that this sector had the largest dollar amount of stock buybacks for the
ten-year period 1995-2004; looking at a single industry eliminates the need to
control for industry effects in the investigation; we collected the data on
options from the firms 10-Ks and in some instances 10-Qs; and we wanted to
keep the sample tractable.
Figure 2 shows the spending on stock buybacks from 1995 to 2005 by
sector for S & P 500 companies. The IT sector spent over $250 billion on
stock buybacks for the ten-year period, surpassing any other sector by $100
billion. The largest S & P companies conducting stock buybacks during the
same ten-year time period are presented in Figure 3. Many of these largest
spenders on stock buybacks are IT sector companies.
We obtained financial information for all eighty of the companies
included in the IT sector but several firms were excluded due to their being
acquired in the 2005 calendar year or their having missing data needed for the
analysis. We ended up with 233 firm years included in the analysis. Table 1
highlights the ten companies in our sample repurchasing the most shares and
having the most stock options exercised for the period 2003 through 2005.
During this period, First Data purchased over 25 percent of their outstanding
shares. Autodesk had stock options exercised in excess of 20 percent of their
outstanding shares and appears on both top ten lists.
Actual stock buybacks were analyzed rather than announced
buybacks, since companies frequently do not fully follow through with the
announced stock buyback plan (Pasha 2002).
Between 1985 and 1996, completed
buybacks totaled $63.3 billion, representing only 56 percent of the stock
buyback announcements of $112.8 billion (Lazo 1999).
We employed a Tobit analysis in our investigation of the
relationship between shares repurchased and options exercised rather than
regression analysis because the dependent variable is constrained to always be
nonnegative. We included control variables for: cash flow per share, the ratio
of cash to total assets, leverage, firm size, the market value to book value
ratio, the total stock return, and the dividend payout per share. In addition
we included dummy variables for fiscal year-end to capture the effect of
general economic conditions. All control variables were determined using
financial data from the year prior to the year with the repurchase activity.
Descriptive statistics and detail on the construction of these variables are
presented in Table 2.
The results of estimating the model are presented in Table 3.
Seven control variables are included to capture factors other than the exercise
of options that may influence repurchase activity. The first control variable
is cash flow per share, CASHFLOW. We expect that firms with greater cash flow
per share are more able to repurchase stock. The next three control variables,
CASH, LEVERAGE, and LNASSETS (log of total assets) are included to capture a
firms financing costs. Firms with a greater proportion of cash to total
assets, CASH, should have more liquidity and financial flexibility. These firms should be more able to
sustain repurchase activity. The variable, LEVERAGE, is the ratio of debt to
assets. Firms with greater leverage have less financial flexibility and are
less able to repurchase shares. Larger firms have lower financing costs than
smaller firms. This should lead to a positive relationship between size,
LNASSETS and repurchase activity. MB is the firms market value to book value
ratio. This variable is included to measure the investment opportunities
available to a firm. Firms with more investment opportunities will be less
likely to repurchase their own shares because they have alternative profitable
uses for their cash. The one-year return, RETURN, is included to control for
overvaluation. If managers engage in repurchase activity because they feel
their stock is undervalued, then firms with higher one-year returns should be
less likely to have repurchase activity. The firms dividend yield, YIELD, is
included to capture the tax clientele effect. Firms that pay dividends may be
reluctant to distribute cash through share repurchases. Finally, we include
options exercised, EXERCISED, to capture the effect of options on the
repurchase activity.
When the model is estimated, the coefficient
on cash flow is positive and significant as expected. This provides evidence
that firms with more cash flow are more likely to repurchase their own stock.
Two of the three variables that capture financing costs enter the model as
expected. There is a negative and significant relationship between leverage and
repurchase activity, and a positive and significant relationship between firm
size and repurchase activity. The ratio of cash to assets, however, does not
enter the model as expected; instead it is negatively associated with
repurchase activity. The coefficients on the three other control variables are
not significant in the model. This lack of significance in these control
variables may be due to the homogeneity in the sample due to the restrictions
on industry membership and the restriction on the sample period.
The association between repurchase activity and stock options
exercised is positive and significant at the 0.01 level. This indicates that
the number of shares repurchased and the number of share options exercised are
associated. Those companies having a larger proportion of stock options
exercised to shares outstanding also had a larger proportion of stock repurchases
to shares outstanding after controlling for financing costs, growth
opportunities, tax consequences, stock underpricing, general economic
conditions, and industry effects. These results provide evidence of an
association between these two events, as suggested by the FASB and numerous
analysts.
Concluding Remarks
The FASB, by requiring disclosure in SFAS
No. 123R of the estimate of the amount of shares to be repurchased during the
period due to stock options exercising, believes that there may be an association
between the number of shares repurchased and the number of stock options
exercised. Specifically, the FASBs intent was to help investors understand the
impact that the issuance of stock options and related stock buybacks can have
on a companys cash flow. These thoughts are shared by numerous others.
According to a Credit Suisse First Boston analysis, stock compensation packages
were responsible for up to three-quarters of the stock buybacks by S & P
firms between 1999 and 2003.
Companies, including Intel, which has repurchased 2.2 billion
shares from 1999 through 2004, dispute this relationship. These companies
contend that numerous reasons exist for repurchasing shares, and that there is
no direct connection between their stock buyback program and options exercised.
This study analyzed all of the companies in the April 4, 2005
Business Week 500 listing in the IT sector to determine if there was an
association between shares repurchased and options exercised for the period
2003 through 2005. The companies chosen were in industry classifications that
typically participate in share buybacks activity. Using a Tobit multivariate
analysis we found evidence of an association between shares repurchased and
options exercised. Results of this study support the FASB contention that there
is an association between shares repurchased and stock options exercised.
Further research is needed to determine if the study results can be generalized
to other industry classifications and to other time periods
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Stuart Don Levy
