Perspective

Share Buybacks and Long-Term Shareholder Returns – The Good, the Bad and the Ugly

Share buybacks are a subject we’ve long discussed internally at TDM. Given that we are structurally set up to own businesses for as long as our thesis holds true, our view is that over the long term, only two things really matter when it comes to shareholder value creation – return on invested capital and the opportunity for growth. Ultimately, the capital allocation decisions a company makes are what drive returns for shareholders.
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Over the last six months, we shared our views on capital allocation and share buybacks with one of our portfolio companies, Block (NYSE: SQ). We believed Block’s current share price and balance sheet strength presented a compelling opportunity to buy back shares extremely cheaply. We pointed to Apple’s repurchase of $660B+ worth of stock over the last decade or so as a powerful case study of how a share buyback program can be used to benefit long-term shareholders.

But buybacks are not always a good thing for long-term owners. Below we share four case studies – Apple (AAPL), The Home Depot (HD), ExxonMobil (XOM), and Bed, Bath & Beyond (BBBY) – which all yielded very different outcomes.

We also dive into the most common arguments we face when discussing potential buybacks with boards and management teams.

We are planning to surface more of TDM’s views on capital allocation in early 2024, including how buybacks fit into a broader capital allocation framework and what boards can do about it.

First and foremost, what is a buyback?

Investors and boards can overlook or misconstrue the fundamental principles of share buybacks. Often, they are labelled as a method to simply ‘return capital to shareholders’ or to ‘offset dilution’. Sometimes they can be viewed more cynically as a way to manipulate the share price or per-share earnings metrics in the short-term1.

In his Letter to Apple Shareholders (2014)2 , we believe Carl Icahn described the appropriate way to think about share buybacks:

‘…a share repurchase is the company making an investment in itself by buying shares in the market at the current price, which we believe to be undervalued, from shareholders willing to sell at that price for the benefit of shareholders who choose to remain investors for the longer term.’

Buybacks as a concept cannot be labelled as either ‘good’ or ‘bad’ for shareholders. The benefit or drawback is dependent on these two questions:

1. Is the company buying back shares materially below their intrinsic value?
2. How does the capital allocation decision to buy back shares compare to alternative uses of capital?

As evidence shows, there are examples where buybacks have both created and destroyed value.

Best in class: Apple

In 2011, Apple commenced an annual share repurchase program that has since become the world’s largest by absolute dollar value.

At the outset, the share price was $12, market cap $350 billion and net cash $26 billion. The current share price is ~$190, market cap $3 trillion and $62 billion net cash.

Over the last 12 years, the company has bought back $667 billion of stock at an average price of ~$100. That is equivalent to approximately 80% of total free cash flow generated over the period.

If Apple had not put in place the buyback program and simply let cash accumulate, the equivalent share price would be approximately $140, or 40% below the current share price.

Apple would need to create $1.3 trillion of incremental value to get to a $190 share price under this scenario. That is almost equivalent business value to Amazon, one-and-a-half Facebooks or six Netflixes.

This has generated Apple shareholders 16x MoM versus 12x MoM in the cash accumulation scenario, the difference between 26% CAGR versus 23%.

Perhaps most importantly for shareholders who have held their shares continuously, their ownership percentage has almost doubled over that time. In effect, their economic exposure to the business going forward has effectively doubled without them buying any stock.

Warren Buffett noted on Apple buybacks:

‘I’m delighted to see them [Apple] repurchasing shares, I love the idea of having our 5 percent, or whatever it is, maybe grow to 6 or 7 percent without our laying out a dime.’

 

The right move: Home Depot

In 2002, a decade before Apple started their buybacks, Home Depot initiated a share repurchase program at a share price of ~$27. Since then, it has deployed almost $115 billion, equivalent to approximately 80% of free cash flow over that period. The buyback program has reduced the number of shares on issue by almost 60%. The share price at the start of 2023 was $290. The Total Shareholder Return (i.e. including dividends) for the intervening two decades was 12x MoM (13% per annum) compared to 3.5x revenue growth and 4x for the broader market performance. In the theoretical scenario where Home Depot simply holds onto this cash, the equivalent share price would have been almost $180 – circa 40% below the actual share price. This delta represents around $250 billion of market cap created through buybacks – equivalent to roughly two Lowe’s, four Targets or 25 Floor & Decors.

Alternatively, there are many instances where excess cash has been deployed to buy shares at unattractive prices. This results in existing shareholders being overpaid at the expense of long-term shareholders.

The bad: Exxon Mobil

Between 2000 and 2015, Exxon Mobil spent $250 billion on repurchasing its own stock (~80% of free cash flow), making it the second largest repurchase program in the world for that period. As it happened, this proved to be a poor capital allocation decision – just hoarding that cash over that period would have resulted in a theoretically higher share price in 2015 (~$86 vs. ~$82). Consequently, the buyback program cost long-term owners ~$30 billion in shareholder value.

There are also extreme examples where share repurchase programs have not only been value destructive but have been a major contributor to the demise of a company.

The very, very ugly: Bed, Bath & Beyond

From the mid-nineties to mid-2000s, the US-listed homewares retailer, Bed, Bath & Beyond (BBBY), had been an inspiring case study for us. It exemplified ‘what great looks like’ for a consumer retail roll-out. Much of for Baby Bunting, Australia’s baby retail category killer and one of our most successful investments, was modelled on BBBY.

By the end of 2004, BBBY was thriving. It had a market cap of $12.5 billion, cash of $1.2 billion, no debt and it produced free cash flow of more than $400 million. That year the company also announced a share repurchase program. BBBY committed to this program every year for the subsequent two decades, often spending more money buying back stock than it generated in free cash flow.

In 2023, the company filed for bankruptcy. It had spent $12 billion of shareholder funds to buy back stock at an average price of $52 per share. This was 40% more than the $8 billion in free cash flow in generated over the period. Shares on issue had reduced by 75% but all the remaining shares were now worth $0.

Theoretically, if BBBY had let free cash accumulate on the balance sheet, the share price would have been $40, roughly equivalent to the share price in 2004 when the program started. Maintaining balance sheet strength would have also avoided the death spiral that ultimately took hold in 2023.

The fundamental point is that buybacks, like any investment decision, are only justifiable when purchasing the asset – the company’s own stock in this case – at an attractive price. To make appropriate decisions on share repurchase programs, a board and CEO must have a view on the intrinsic value of their company’s stock.

Typically, Warren Buffett spoke to this sentiment more artfully than we can when he said:

‘Can you imagine somebody going out and saying, we’re going to buy a business and we don’t care what the price is? You know, we’re going to spend $5 billion this year buying a business, we don’t care what the price is. But that’s what companies do when they don’t attach some kind of a metric to what they’re doing on their buybacks.’

Or as he put more prosaically:

‘Buying dollar bills for $1.10 is not good business for those who stick around.’

The growth company fallacy against buybacks

At TDM, we invest in higher growth businesses (usually 20% per annum or more). Often, there is a misconception that share buybacks are the exclusive reserve of low growth businesses with no attractive internal uses of capital. We disagree.

When we receive push-back from boards and CEOs, it usually falls into two categories:

1. ‘A share buyback will signal to the market that we have gone ex-growth’
2. ‘We must keep excess cash available for strategic flexibility’

For those considering a repurchase, the sentiment we hear most commonly is:

3. ‘We should do a buyback to offset share dilution’

To deal with each of these individually:

1) ‘A share buyback will signal to the market that we have gone ex-growth’

As critics contend, every dollar deployed to repurchase shares is a dollar that isn’t retained and reinvested in wages, research and development and future growth. Furthermore, many companies believe that the mere action of announcing a buyback signals to the market that the business has exhausted its growth opportunities – it has gone ‘ex-growth’.

We believe this concern is often a fallacy. For example, we advocated for major share repurchase programs to be implemented at LogMeIn in 2013 and Ellie Mae in 2014. At the time, both companies were growing revenue in the mid-teens. In the subsequent two years, revenue growth reaccelerated to 30%+. The share prices of both companies tripled over the same period of time.

Put simply, buybacks can ensure that residual capital is put to good use, rather than wasted in the hunt for superior growth opportunities that simply may not exist.

One can hardly argue that Apple didn’t have abundant growth opportunities ahead of it in 2011, nor that it hasn’t subsequently reinvested in these. Over the course of its twelve-year repurchase program, it simultaneously spent almost $150 billion on R&D – not to mention its acquisitions. The more undervalued the stock is, the higher the bar needs to be to justify further investment in growth. In Apple’s case, this meant somehow investing in something that could outstrip a 26% return (with of course the benefit of hindsight).

Conversely, there are also examples of high free cash flow businesses re-investing too much into new growth initiatives. This can result not just in poor returns on capital but also leads to the business overextending itself and dividing its focus. Hindsight would suggest rather than scrambling to find ‘good’ uses of capital internally, a more thoughtful approach to capital allocation and buybacks would have been far more value accretive.

A perfect case study of this recently is Airbnb.

In 2019, Airbnb spent $4 billion in operating costs (non GAAP), up almost 50% on the prior year, growing revenue at ~30%. It produced ~$500 million of free cash flow at a 14% margin. At the time, Airbnb was investing in over twenty new growth initiatives.

As the pandemic became an existential crisis for the company, Airbnb cut their cost base by almost 30%, ceased all new growth initiatives, and refocused all of their opex on the core business.

Fast forwarding to 2022, Airbnb also spent $4 billion in operating costs and produced 40% topline growth. This year, it will grow revenue at close to 20%. The result was $3.4 billion of free cash flow at a 40% margin. Simultaneously, the company has announced two share repurchase programs for $2 billion (2022) and $2.5 billion (2023), equivalent to approximately 60% of total free cash flow.

It begs the question as to why a certain stigma remains attached to businesses using buybacks as a valuable use of excess cash. We can only imagine it being the result of fewer companies likely meeting the following criteria: fast growth, producing excessive amounts of free cash and trading significantly below fair market value. More importantly, the ex-growth commentary focuses narrowly on growth, overlooking the role buybacks play in per-share growth, which remains the ultimate driver of shareholder value.

2) ‘We prefer to keep excess cash available for strategic flexibility’

We view a strong balance sheet with capital flexibility to be an important competitive advantage. In an uncertain world, being able to control your own destiny is of fundamental importance. We will always take a conservative stance on balance sheet flexibility – our portfolio companies are almost always in a net cash position with minimal or no debt.

Having said that, we believe that free cash flow positive companies growing quickly and/or with large cash balances have a duty to the owners of the business to outline how they’re thinking about capital allocation beyond ‘strategic flexibility’.

This duty is based on the premise that capital allocation is one of the most important determinants of a company’s long-term success and one of the most valuable skillsets a business leader can possess. As such, socialising a framework displays to shareholders that the business is a safe and worthy steward of their capital. Worse still, in our view the absence of one can signal a lack of foresight and consideration. ‘Strategic flexibility’ as a generic catch-all does not reveal the nuances every business faces, be it regulatory burden or key investment decisions.

Moreover, when cash balances and/or the near free cash flow outlook are significant, ‘strategic flexibility’ quickly becomes downright illogical. As Tim Cook stated in 2012:

‘We have used some of our cash to make great investments in our business through increased research and development, acquisitions, new retail store openings, strategic prepayments and capital expenditures in our supply chain, and building out our infrastructure… Even with these investments, we can maintain a war chest for strategic opportunities and have plenty of cash to run our business. So we are going to initiate a dividend and share repurchase program’

3) ‘We should do a buyback to offset share dilution’

We do not subscribe to the view that by default share repurchases are a sensible means of offsetting stock dilution – something usually caused by large stock-based compensation programs. We believe best practice capital allocation relies on both decisions – to issue and to repurchase stock – being made independently.

By their very definition, share buybacks are only valuable when the stock is intrinsically cheap, and so the premise that companies should be continually buying back its stock to offset dilution isn’t fully formed. Through this lens, buybacks used to offset dilution when the stock is cheap is of course very important to long-term shareholders.

Capital Allocation Frameworks – to be continued

We have thought deeply about capital allocation frameworks both as investors and as board members at TDM for almost two decades and will be sharing our views on how companies should assess competing uses of excess capital more deeply in the coming months. Until then, we welcome any comments on the above.

Written by James and Hamish

Footnotes

About the author

James is a member of the TDM Investment Team. Alongside his day-to-day investment duties, he supports Block and advises other portfolio companies on growth strategy.

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