Stock buybacks: the corporate con you're still falling for.

Mark Fischetti is a writer in Great Barrington, Massachusetts.

Instead of putting capital into new Plants and improved products, America's CEOs bad a better idea: They invested it in themselves

Late one night, while waiting for the company limousine, you pour yourself a drink and ponder your life as a CEO: the bonuses, the golden parachute, the private elevator with the polished doors. Perfect-or rather, it would be, if it weren't for those busybody shareholders constantly whining that their stock is stalled. What to do? Invest in a new plant and expand production? Pay a few dweebs in white coats to develop some new techno-doohickey that'll really wow Wall Street? . . . Nah, the very thoughts make you tired. Life is so unfair, you think. If only you could boost stock prices, get rid of some shareholders, and maybe reap a few million bucks for yourself in the process. All without really working.

You can. In fact, CEOs have been doing it for years, thanks to Wall Street's best-kept secret: the stock buyback plan. For a classic demonstration, consider the owners of the Washington Redskins. Back in the early seventies, Jack Kent Cooke, Milton King, and Edward Bennett Williams sat on the board of Pro Football Inc., the parent company of the Redskins. From that position, they quietly bought out other shareholders to take complete ownership of the team. It was quite an expensive purchase-which is why they used other people's money to make it.

During the sixties, George Preston Marshall owned 520 of the 1,000 shares in Pro Football, Williams and his two cohorts held minority positions, and the public held the rest. As Williams came to control more of the daily activities of the company, he directed Pro Football to begin buying back public shares, using company money, for the sole purpose of increasing the board members' relative share. Then, after Marshall died in 1972, Williams--the executor of Marshall's estate-had Pro Football buy and retire Marshall's 520 shares. That transaction alone cost Pro Football $8.8 million, but when they were through, Williams, Cooke, and King owned the entire franchise.

Problem was, the Redskins had nowhere near that kind of money. So the trio put Pro Football into debt-major debt-to finance the purchases. Although the three owners wouldn't talk, sources at Sports Illustrated and The Washington Post put the debt service alone at between $600,000 and 1 million per year. And Joe Fan picked up the tab. By 1978, the Redskins had the highest ticket prices in the National Football League. Williams, Cooke, and King had managed to bill consumers- in this case ticket buyers-to get control of the company, and of its profits. Today, industry watchers estimate that, thanks to soaring TV revenues, the franchise is worth over $150 million, 10 times what it was worth in 1972. There are no outside stockholders left to benefit from that surge. And Cooke, the only surviving member of the original troika, sure hasn't shared the wealth (in the form, say, of cut-rate tickets) with the little people who made it all possible.

Stock response

By now, we've all heard the cautionary tales: How Kravis, Bass, and other corporate raiders made billions during the eighties while driving American companies into debt, impervious to the impact on jobs or national competitiveness. Stock buybacks have many of the same effects-they just work more insidiously, since nobody's complaining. Last year, U.S. companies bought back more than $12 billion in stock, according to Goldman Sachs partner Steven Einhorn. That money generally didn't result in better cars, lower food prices, or even cheaper tickets to Redskins' games. It didn't result in leaner, smarter business management. It didn't help us as we slid further into recession, unable to trade our wares in a tight international market. It did result in hefty profits for the executives who engineered the deals.

In major food, metal, manufacturing, and other companies across the U.S., CEOs divert millions of dollars from the quest for innovative products, breakthrough production technologies, cleaner waste management, and better-paying jobs. Then they spend it all manipulating the market to enrich themselves and their shareholders.

So why haven't you heard about this corporate con? Because most business managers, stock analysts, and reporters have fallen for the buyback's illusory benefits.

Even the most savvy dailies and trade magazines are infatuated with buybacks. As Quantum Chemical took on crippling loans to finance a buyback, Forbes ran a story called "Saddled with Debt But Still Able to Grow." A Wall Street Journal story about dividends fueled by buybacks bore the headline, "Metals Producers Are Basking in a Cash Glow, And Move to Share the Luster with Holders." A Tenneco buyback, announced in the face of takeover threats, was described by Business Week as "potent shark repellent," even though Tenneco would have to take on $3 billion in debt to finance the purchase.

A buyback works like this: Say there are 1 million shares of stock in XYZ 

Inc., a defense contractor that builds sophisticated Zealot antimissile missiles. XYZ executives own 500,000 shares of the company, and the other 500,000 are held by various investors. If XYZ officers want to increase earnings per share, or reduce the relative ownership of outsiders and, with it, their influence on the company, they can buy up the public shares, using the company's money.

When the shares are purchased by the company, they are "torn up"-they cease to exist, since a company cannot own stock in itself. If XYZ executives buy 100,000 shares, for example, they then control 500,000 shares out of 900,000, or 55.6 percent, instead of the 50 percent they used to control. Why doesn't this powerplay gall small investors? Because of the built-in bonanza: Even if the company's earnings remain level, they are divided over 900,000 shares instead of I million. Thus, earnings per share increase.

Furthermore, after a buyback is announced, the share price tends to rise a bit, thanks to the conventional wisdom among stock traders that higher earnings per share mean a stock is more valuable, and therefore is worth a higher price. Brokers and analysts recommend that their clients buy XYZ, and the activity further drives up the price per share.

So XYZ has more control, the stockholders make more money, and the shares increase in value. What's so bad about a buyback? Well, there's one minor detail: Buying back shares isn't free. If XYZ execs want to buy 100,000 shares, and the shares are trading at $30, they have to spend $3 million of the company's money to buy them.

That means one of two things: large cuts in the company's cash flow or, if XYZ's execs borrow money to complete the transaction, big corporate debt. Either way, huge quantities of cash are diverted from long-term improvements at XYZ-say, inventing a more sensitive homing device for the Zealot, decreasing costs of production, accelerating and simplifying delivery during intemational crises. Such capital investments would surely pay off in the long run, making the Zealot more attractive to nations now smitten with the French competitor. Even a small increase in orders would boost the depressed region where XYZ is located, and possibly give jobs to the 15 percent of the local population now unemployed. But instead, XYZ spends its $3 million on a corporate facelift: the artificial price boost a buyback gives a stock. Unfortunately, like a facelift, that boost usually doesn't last long. For proof of that, you don't need XYZ. Just take a look at the venerable Washington Post, where blind faith in the buyback may ultimately hurt not just its stockholders, but its coverage.

Post-mortem

Throughout the eighties, Chairman Katharine Graham and her Washington Post Co. used buybacks to drive the share price up and up, to a high of $311 in October 1989. Then the tide turned against publishing, but Graham's company kept buying, spending $175 million in the first quarter of 1990. Instead of going up, the stock price slid down to $250. The company bought more. By January Washington Post stock had declined to around $190. Not only did the share price lose ground in 1990, but earnings per share did as well, dropping more than a dollar from the 1989 $15.50 dividend. President Richard Simmons recently predicted another decrease in earnings per share for 1991.

So, in the long run, the buybacks not only failed to bring better earnings, they virtually ensured a worse Washington Post. In the midst of the recession, with ad lineage off 11 percent from a year ago, the Post could use the hundreds of millions it spent on buybacks to run more stories, hire more reporters, and go after more potential advertisers. But most of that money is gone.

The Post was far from alone in its costly infatuation. In the financially roaring eighties, it was indeed hard to find a buyback that didn't work in the short tenn. The economy was growing, and many companies had more cash on hand than they could handle. So they bought back stock, driving its price up and making their shareholders happy. With easy credit, often based on junk bonds, even companies that weren't doing well could play the game.

After Black Monday, buybacks became even more attractive, as the stock prices of hundreds of companies took a nose dive. Executives at solid firms knew their stock would rebound, at least somewhat, so they bought their own shares because it seemed like a sound investment. The corporate raiding following the crash accelerated the practice. If your company was threatened by a takeover artist, one of your best defenses was to gobble up so much of your own outstanding stock that the raider could not gain control, or to bolster the stock price enough to make th takeover too expensive.

Once learned, the buyback proved a tough habit to break. Today, the economy is no longer booming, credit is no longer easy, and the raiding has largely ceased. The stock market has been slipping for almost a year now. The hemorrhaging real-estate market is dragging down investors nationwide, and economists are finally saying the R-word. It's riskier than ever to go into debt. But many executives are still playing the buyback game. Why? Because besides offering a short-term gain to shareholders, buybacks often mean a windfall for CEOs.

Purina cravings

The desire of big stockholders for quarterly profits has driven many a chief executive to forget about long-term strategy. Especially when the chief executive himself is a big stockholder. There's no better example of this than Ralston Purina, the St. Louis-based owner of everything from dog food to Wonder Bread to Chex Mix.

In 1986, Ralston's board made a breathtaking offer to the company's top execs: If the stock price hit $100 and stayed there for 10 consecutive trading days, the executives would take home a bonus of 491,000 free shares, worth a cool $49.1 million. Ralston's chairman and CEO, William P. Stiritz, would get 160,000 of those shares, three top vice-presidents would get 40,000 shares apiece, and other managers would get smaller awards. At the time, the $100 mark seemed a pretty tall order: Ralston stock was selling at around $60 a share. But the brass ring was enormous. And to Stiritz, the way to reach it was perfectly clear.

Since taking over in 1981, Stiritz has spearheaded one of the most aggressive and prolonged buyback programs ever seen in the United States. Under him, Ralston has spent almost $3 billion, more than 95 percent of its earnings, on its own stock. By early October 1990, finally, the grail was in sight. So Ralston directors authorized another buyback of 2 million shares. That put them over the top. Stiritz got his 160,000 shares, worth $16 million.

Ralston argues that its stock plan benefited not just Stiritz but all shareholders, and quite handsomely at that; while the company's earnings have doubled since Stiritz took over, the per-share profits have quadrupled. But now that the plateau has been reached, Ralston's stock is going down. Indeed, by early January, the stock price had slipped to $93.

Ralston has always generated a lot of cash: $250 million a year in play money, after dividends. But it also carries almost $2 billion in long-term debt, most of it used to finance buybacks. "The buyback has been Ralston's only game," says Timothy Ramey, an analyst with County NatWest in New York City. "They haven't done much to improve performance."

Ralston, Coca-Cola, and other cash-rich retailers are particularly susceptible to the buyback disease. Managers at those firms argue that, especially during a recession, buybacks are their safest investment. What if they spent the cash acquiring a company that wound up doing poorly? Or overspent to develop new products consumers don't want, and then wasted even more money on large ad campaigns to promote those products? To them, a buyback is a small risk with a predictable return.

Such cautious management may be shortsighted and fainthearted, since risks and sturdy R&D drive the best American companies. But it also may be disingenuous. A thorough evaluation of a buyback's merit must include this simple question: Who gains the most? Clearly at Ralston the answer is not American consumers, but the company's top executives. And their stock-driven compensation package does not stand alone. "In the last 10 years the emphasis in senior executive pay has shifted from salary and cash awards to stock options," notes Ted Buyniski of Sibson & Co., a Princeton, New Jersey, consulting finn that specializes in compensation. For many top executives, as much as half their total pay is now tied to increases in stock prices and stock earnings."

The object of stock options, Buyniski says, is to focus executives on measures that increase shareholder wealth. But many executives have concentrated almost exclusively on improving short-term stock performance. With a buyback, they can fulfill their mandate and profit personally as well, without improving the company or its products. "If you're going to structure compensation to stock options," says Buyniski, "tie it to long-term performance." Unfortunately, only a few companies are taking Buyniski's advice.

Catch-as-catch con

Granted, for recession-proof, liquid companies like Ralston or Coca-Cola, buybacks may be lazy, but they probably won't prove catastrophic. But for companies in industries with cyclical downturns, they can.

The real danger of buybacks comes when a company should be using its money to reduce debt or just survive. "If they try a buyback and the stock goes up, but it comes right back down once the buying has stopped, they've blown the money they could've used to keep their operations going," says Len Hyman, an enlightened analyst with Merrill Lynch in New York City. That's advice several metals companies could stand to heed.

North American steel, aluminum, copper, and nickel concerns that were ailing in the early eighties found themselves wading in cash by the end of the decade, thanks to improvements in efficiency made in response to competition from overseas makers. That's the good news. But while Alcan Aluminum could have used its new money to wipe out its debt, and Phelps Dodge and Inland Steel might've financed a permanent comeback, pressure from investors got to them. All three began buyback programs and retired shares, and announced special dividends.

Alcan, based in Montreal, has continued on this course. It bought back almost 5 million shares in fiscal 1990, and then announced in October that it would seek to purchase 15 million more-almost 7 percent of its outstanding stock-in 1991. At the October share price of $19.25, the transaction would cost $480 million. Duncan Curry, Alcan's manager of investor relations, defends the company's practice, saying "it would be a fair criticism to say we should use the money to invest in R&D if we were solely using the money to buy shares, but we budgeted $1 billion in 1991 for a capital spending program." Besides, he adds, since the metals industry is cyclical, investors want cash when it's on hand. And the company does what it can to deliver.

You can take it with you

Of course, resisting stockholders' shortsighted demands to preserve the long-term health of the corporation takes plenty of tact and diplomacy. But giving in may mean giving up the store. Just ask CBS, which capitulated to the desires of a powerful stockholder who already had both feet in the grave.

In December, CBS Inc. announced a huge buyback-10 million shares, at a cost of $2 billion. The reason: The estate of company founder William S. Paley, who died in October, found itself with an enormous estate tax bill due by July 1991. Paley's family didn't have nearly enough cash, so it initiated discussions with CBS about a buyback. In order not to change the profile of current ownership, CBS decided to make a fixed price, "pro rata" offer, meaning CBS would buy the same percentage of each shareholder's stake. The company would pay $190 for each share.

Paley's estate, which owned 1.4 million shares, or 5.5 percent of those outstanding, will make 108 million on the deal. But one other entity will also profit greatly-Loews Corp., which owns 24.5 percent of the outstanding shares. Loews originally bought its shares at an average of $125; the prorated sale of its stake, at $190 a share, will result in a profit of $165 million. Who runs Loews? CBS President Laurence Tisch.

In December, CBS announced it expected a fourth-quarter loss, the first quarterly loss in the company's long history. The bad news was caused by a $55 million after-tax loss from coverage of Major League Baseball, lower than anticipated ad revenues, and higher costs sustained by news coverage of the Persian Gulf build up. Fourth-quarter earnings per share, it said, would be down from $ 1. I 0, where they had been each quarter for two years. Furthermore, CBS said it expected "unfavorable earnings" in 1991 because of the worsening advertising climate, continued losses on baseball coverage, and the loss of lucrative contracts to air the Super Bowl and the NBA playoffs.

CBS admitted that "the loss of income from the $2 billion used to consummate the [buyback] offer" will have a "dilutive impact" on earnings per share, which "will outweigh the effect of having fewer outstanding shares." In other words, the usual effect of a buyback-increased earnings and stock price-will not occur. In fact, due to the announcement of expected losses in 1991, coupled with the large evaporation of cash, the stock dropped precipitously in January, after the buyback was completed.

All this to serve one family's estate-tax problem. To be fair, William Paley did found the company and was essential to its growth, making his shareholders wealthy in the first place. But the buyback could be a critical blow in a recession. At the very least, it will hurt CBS's employees. In its 30-page announcement of the buyback and its anticipated effects, CBS noted that to mitigate 1991 losses it will reduce operating costs "wherever possible," implement "reductions in personnel levels, both by attrition and otherwise," and reduce "the amount of annual compensation the company pays its affiliated stations."

Whitmanhandied

CBS's buyback will roughly halve the trading value of the company, leaving the stockholders with about 13 million shares worth about $2.3 billion. That's a virtual invitation to takeover kingpins who, prior to the buyback, would have needed $4 billion to cover outstanding shares.

That a buyback would make it easier for a corporate raider is a new twist. Usually it's the other way around. Defensive buybacks came into vogue after the crash, when raiders like Carl Icahn and Asher Edelman sought to accumulate undervalued stock. Executives responded by buying up outstanding shares to ensure either that the raiders couldn't get control or that the stock price would be out of reach.

Perhaps in these cases the buyback can be justified as a small sin necessary to prevent a greater one-a bogus takeover that would result in the dismantling of a company and the loss of many jobs. Phillips Petroleum, for example, successfully used a buyback plan to fend off T. Boone Pickens Jr. Goodyear repurchased shares to beat back Sir James Goldsmith.

But there is a price to be paid for this tactic, and some companies have paid dearly. Consider Whitman Corp., a $3 billion consumer goods conglomerate in Chicago best known for its Whitman Sampler chocolates. In September 1988 Whitman was already buying back 500,000 shares a month from the 107 million shares outstanding. Then it announced it would buy back 3.4 million more shares, worth about $125 million, from Carl Pohlad and MEI Diversified Inc., of which Pohlad was chairman. Whitman feared Pohlad and his clan were seeking control of the company.

Whitman borrowed money and got the shares, and Pohlad lost interest. Some observers sympathize with Whitman's execs, saying they had no other option. But as County NatWest's Ramey observes, "A takeover might have been the best thing that could have happened for shareholders, considering what's happened since." At the time of the Pohlad threat, Whitman's stock was selling at around $36. By May 1989, eight months later, it was at $26, and Whitman had $1.6 billion in debt. By the end of 1990 the stock was trading at around $18, and Whitman was selling off divisions to raise money. With executives like that, who needs raiders?

Rediscovering rocket science

Looking back over the eighties, Kevin Phillips recently noted that, more and more, people speak of American economic hegemony in the past tense. The buyback is one of the many corporate cons that make such laments ring true. As dividends shrink and the market slides, maybe the very shareholders who benefit from buybacks will start to question why highly paid executives aren't reinvesting revenue to improve the real growth of their companies.

"Buybacks are easy," says Ramey. "They're not rocket science. Shareholders have to wonder why they're paying top executives millions of dollars a year if all they do is buy back stock with the cash the company earns." If more reporters, analysts, and investors began to see through the buyback's sham virtues, more CEOs would start investing in innovation-which would mean a dividend not just for captains of industry and their stockholders, but for dwindling American competitiveness, too.