Tuesday, December 28, 2010

Share buybacks

Saj Karsan has published a blog post on the poor timing of corporate share buyback programs. He observes that companies often repurchase their shares when the market is most enthusiastic about their prospects, and the share prices are correspondingly high. While Saj makes an excellent and important point, I want to defend some of the companies Saj sites as examples in his post.

A share buyback is a way for a company to allocate capital that cannot be productively deployed in its operations. The company can pay the money out as a dividend, or use it to repurchase some of its stock. By reducing the number of outstanding shares, the company increases the share of future earnings that an ongoing investor will receive. Is this increased share of future earnings worth the money spent on the stock repurchase, or would shareholders be better off simply receiving a dividend?

The decision by a company to repurchase its own stock can be viewed as any other investment decision. Instead of buying its own shares, the company could have purchased shares of another business, which would have also contributed to future earnings of the company's shareholders. So, whether a buyback is a good investment comes down to price. Companies should only repurchase their shares if those shares are undervalued.

As Saj points out, the overall record is not good. Companies tend to repurchase their shares at the wrong time, when the share prices are high, and to slow down their repurchases when the share prices are in fact attractive. This is understandable: prices are generally high when companies have strong earnings and thus have money to spend on buybacks. But it is not excusable, as it wastes shareholder equity.

At the same time, long-term buyback records are quite rational for several companies Saj sites as examples of poor buyback timing in the near-term. Let's look at Lowe's (LOW). Here is how the number of outstanding shares of LOW has been changing over time:

We see that Lowe's has been buying back its shares between 2006 and 2008, and then again in 2010. Share buybacks were apparently on hold from 2008 till 2010. This timing is indeed imperfect, since LOW shares were cheaper between 2008 and 2010 than in the years immediately before or after. However, let's put this in the longer term perspective. Here is a look at LOW's price-to-book ratio for the past 16 years:

Since 2007, the price of Lowe's shares has been low by historic standards, compared to the value of underlying shareholder equity. While Lowe's may have started buybacks too early, and not have perfectly timed them to the short-term market swings, their long-term timing is quite reasonable.

A similar picture emerges when we look at Walmart (WMT).

WMT had significant buybacks between 2003 and 2005, in 2007, and after 2009. Looking at their P/B ratio, we conclude that the relative price may have been too high in 2003, but certainly looks reasonable in the more recent years.

Timing of corporate share buyback programs is an important consideration in making stock investment decisions. Companies that overpay for their own stock destroy shareholder value, and should be avoided. Companies that repurchase shares when the price is right, create additional value for their investors, above and beyond the value generated by the underlying business. At StockPup.com, you can find tools to evaluate share buyback programs over the long-term of 15 years or more.

Friday, December 17, 2010

Staples and OfficeMax – same business, different results

In this article we compare two office product distributors – Staples (SPLS) and OfficeMax (OMX). Both sell through retail stores, web and mail catalogs, as well as delivery contracts with larger customers. With annual sales of $24B, Staples is more than 3 times larger than its rival, which generated $7.2B in sales last year. But the differences go much deeper than size. From the perspective of long-term shareholders, Staples exemplifies a consistently profitable business that is good at allocating and growing its capital. OfficeMax, on the other hand, is a story of capital tied up in barely profitable operations, and diminished by corporate actions

Over the past 14 years, Staples has nurtured the equity of its shareholders from $1.27 per share to $9.37 – representing a compounding annual growth rate (CAGR) of 15.3%. Including dividends, the shareholder wealth grew from $1.27 to $11.18. That’s a solid CAGR of 16.8%.

(circled letters are corporate event indicators that you can explore on the StockPup.com web site; "M" indicates M&A activity)

The equity of OfficeMax shareholders, in comparison, has been mostly flat, with no compounding to speak of, and significant equity destruction in recent years.

OfficeMax as we know it was formed in 2003, when Boise Cascade Corporation, a paper and wood products manufacturer and office product distributor, acquired the original OfficeMax, Inc. (data prior to 2003 is for Boise Cascade). The paper and wood business was spun-off in 2004, and the company changed its name to OfficeMax Incorporated. Neither before nor after the 2004 merger, however, was the company able to grow shareholder equity.

The 2003 acquisition loaded the OfficeMax balance sheet with goodwill and intangibles, which were subsequently written off in 2008. The $1.3B write-off represented the entire purchase price of the original OfficeMax! OfficeMax has further demonstrated an ability to decimate shareholder equity via corporate action: in 2008, in addition to the aforementioned $1.3B write-off, the company recorded a $735 impairment charge on a note guaranteed by Lehman Brothers, in the wake of the Lehman Brothers bankruptcy.

The growth of Staples has not been entirely organic either – Staples acquired Quill Corporation in 1998, bought the European mail order businesses of Guilbert SA in 2002, and acquired Corporate Express in 2008.

While the Quill acquisition diluted Staples shareholders by some 20%, and the Guilbert SA and Corporate Express acquisitions added close to $1B and $3B of goodwill and intangibles, respectively, to the balance sheet, neither has resulted in write-offs or significantly affected the company’s ability to generate returns. The median ROE is around 16%, and the median ROA is 7.3%.

Staples is under significant pressure due to the recession. Its Retail segment (about 40% of overall sales, and half the profits) was hit by a 2% year-on-year decline in same store sales. A similarly sized Delivery segment has grown sales at a modest 8% last year. And the faster growing (13% y-o-y) International segment remains relatively small (21% of sales and 7% of profits). Despite this challenging environment, Staples remained profitable and achieved a respectable ROE of 12.6%, giving hope that ROE will recover to its historic 16% level when conditions improve.

By comparison, the median ROA for OfficeMax is a meager 1.1%, and the ROA is close to zero.

Throughout OfficeMax history, years of modest profits alternated with periods of losses. Keeping this long-term perspective will protect investors from extrapolating a good year or two into future earnings growth.

Compare this with the consistent earnings history of Staples:

We believe that Staples is attractively priced at a historically low price to book ratio of 2.4. Given its healthy balance sheet and limited growth opportunities, we would like the company to continue its share repurchases, suspended after the Corporate Express acquisition.

Examining long-term fundamentals of companies such as SPLS and OMX, and considering their long-term records in handling shareholder equity, is critically important for investors who want to select the winning investment in a particular industry, or make long-short pair investments. Staples and OfficeMax make for one such potential long-short pair, as do Walgreens (WAG) and CVS Caremark (CVS) – two companies we compared in a previous article. At StockPup.com, you can find a wealth of long-term analytical charts and data covering over 15 years of corporate fundamentals, including all charts and corporate events mentioned in this article. Registration is free.