The Best Use of Corporate Cash: Acquisitions, Buybacks, Debt Reduction or Dividends?

"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett

Buybacks, if pursued with discipline in the manner Buffett describes, should work out very well for shareholders.

Unfortunately, in practice, buybacks don't always work out as well as they ought to for shareholders.

The reasons? Too often executives end up buying shares back, if not high, certainly not cheap. Alternatively, an expensive acquisition will be chosen when the company's own stock is right there available to be bought on the cheap.

Weak execution and the misalignment of owners (shareholders) and management objectives is usually the culprit.

Plenty of evidence supports this unfortunate reality.

Now, a senior management team doesn't generally come forward and say they behaved in ways contrary to shareholder interests. Management actions, examined objectively, in time reveal the real story.

Here's what Jason Trennert had to say in this Barron's article:

...buybacks may just "enhance the reputation of corporate treasurers as poor market timers," at a time when market cycles are growing shorter.

How management should allocate the resources (cash on balance sheet and future free cash flow) of owners for things like: acquisitions, debt reduction, buybacks, and dividends (of course, increases to capex is also an option) is specific to each company.

The list of possible scenarios is long. Some companies have lots of debt to pay down. Others, little in the way of internal investments yet otherwise strong businesses (See's Candy comes to mind if it were a stand alone public company). Many have solid businesses now but difficult to understand fast changing competitive threats with the holding of excess cash viewed as a good defense.

Naturally, there are many other scenarios. One size does not fit all in capital allocation decision-making.

Having said that, buying back your own company's stock when it's clearly cheap is frequently a great low risk way to create shareholder value.

"When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended." - Warren Buffett

Previous posts on share buybacks:
Sanofi-Aventis: How Not to Spend $ 18.5 Billion
Sanofi to Buy Genzyme for More Than $ 20 Billion

Unfortunately, the track record is spotty at best as this Barron's article from earlier this year points out:

Beware The Buyback Craze

Buffett has said stock buybacks makes sense when they're selling below intrinsic value (calculated conservatively) and if the business and balance sheet are strong enough.

So not all buybacks work out for investors. Those one's that do not are mostly the result of ineptly buying high. When executed intelligently, buybacks work very well and also reveal that management actions are driven by shareholder wealth creation.

"By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders." - Warren Buffett

What's a good recent example of the expansion of domain if not necessarily shareholder wealth? The following may fit the bill. Check out this Barron's article on Sanofi's (SNY) offer for Genzyme. Here's what CEO Chris Viehbacher had to say when asked about buybacks on a conference call:

"I personally don't believe that buybacks add any shareholder value."

That acquisition may work out but that doesn't make this flawed thinking any less an issue for investors. The ignorance of basic math may seem puzzling but there is no shortage of CEOs that will let math get in the way of the desire to grow the empire even if it may cost the owners some wealth.

When a CEO is justifying the price paid and merit of a deal shareholders need to read between the lines.

My conclusion, somewhat sarcastic, has been that the words strategic and/or synergistic used in the context of justifying the high price paid by the acquiring company for its target should be considered code for I'm going to overpay for an acquisition to grow this company at shareholders expense. In many cases, a company's own stock is selling below intrinsic value and there for the buying when this behavior occurs.

A straightforward low risk way to create per share value is available yet the riskier voyage is chosen instead.

Personally, if I couldn't find a plane and needed to get across the ocean I'd take a ship. All too often, choosing an acquisition over a buyback seems the equivalent of attempting to get across the ocean riding on a sailfish when a perfectly good ship is available.

"Smart people aren't exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose..." - Charlie Munger

You just need a management team in place that knows how and when to allocate capital wisely with increasing shareholder value its real first priority.

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The Best Use of Corporate Cash: Acquisitions, Buybacks, Debt Reduction or Dividends?
The Best Use of Corporate Cash: Acquisitions, Buybacks, Debt Reduction or Dividends?
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