There are three ways to boost shareholder value.
The first and best is to raise revenues. This can only be done when there is more demand for a company’s product. More demand = more opportunities, more market share, and more cash flow. It’s the best kind of growth, and the kind that all growth-oriented investors (and many value investors) focus on. This can be achieved by investing more in the business, in what is called “capital expenditures,” to improve the firm and prepare it to attract more revenue in the future.
The second is to cut costs. If revenue growth is tapped out by saturating a market, companies can look for ways to make operations more efficient, cutting out unproductive or low-profit operations, or replacing costly operations with lower-cost operations through capex, R&D, and other investments. While those capex costs can hurt expenses in the short-run, if they bring overall operating margins down, it is considered accretive to shareholder value and will boost shares over the long term (or in the short term if the market really understands what’s going on).
The third is financial engineering. There are many forms of this, but for now we will focus on share buybacks. This is when a company buys back its own shares and removes them from the float in the public market. This has several impacts, but the most important is raising earnings per share. Since EPS is a ratio of earnings/shares outstanding, lowering the denominator will raise the total EPS. This in turn should cause the stock’s price to rise to keep its P/E ratio from falling too low.
These are not mutually exclusive, and many companies look to raise revenues and cut costs at the same time. However, when it comes to share buybacks and capex, there is a contradiction. You cannot use the same dollar to buy back shares and invest in future growth.
The Idea of Share Buybacks
With share buybacks, you are essentially telling the market that you feel the shares are undervalued relative to their intrinsic value. If the shares are priced under book value of the company, buying back shares is essentially providing an instant return on invested capital, making it a no-brainer for a lot of companies.
It’s such a no-brainer, in fact, that it has become a huge force in the market. As Bloomberg reported last year, almost all S&P earnings were spent on buybacks and dividends in 2014. This kind of massive trend has its critics, but for investors the bottom line is clear: companies are buying back shares at a record place, injecting demand into the market for their shares.
But it also means they are not using that money on capital expenditures. For companies like Coca-Cola (KO) or Procter and Gamble (PG), this isn’t too big of a concern. But for technology companies, this may be a problem.
Tech and Buybacks
Technology companies, after all, rely on innovation to create new products and markets. Imagine an AAPL without the research and development that created the iPhone. For that matter, imagine a TWTR, FB, T, or TMUS without an iPhone. Tech R&D not only expands revenue growth for tech companies, but creates new marketplaces and sectors.
When tech companies choose to spend money on share buybacks and not on research, they are sending two signals to the market. One is that they feel their shares are undervalued. But the second signal is more dire; the company cannot find valuable investment opportunities in technology that are worth spending that money on R&D.
Recently, share buybacks have been dominated by IT companies. Of the top 10 companies buying back shares, six are IT companies: IBM, AAPL, MSFT, CSCO, ORCL, and HPQ. Combined they have spent $260 billion on share buybacks.
Most recently, Qualcomm (QCOM) saw its shares pop on news that it would buyback $15 billion worth of shares after its last share buyback program finished. That’s $15 billion that will not go into research and development.
The share buyback bonanza in tech indicates a few things. For one, it shows that tech is mature. These companies are over 20 or 30 years old (in IBM’s case, much older). The idea of tech being dominated by growth firms no longer holds water. This may mean that IT itself has become a mature market, and that we cannot expect more growth from it in the future.
Or it could indicate a timidity amongst the largest companies about the future. Having gotten to the behemoth stage, the firms are now scared about high-risk investments in what GOOG calls moon-shot programs. Considering many of GOOG’s own moon-shot programs are unprofitable and have little to show for themselves (the search for immortality, Google Glass, Google Plus), the trepidation is understandable. But it also indicates that we remain in the macro environment that Larry Summers calls secular stagnation.