Saturday, September 3, 2011

Lesson 8: Pros and Cons and Scams of Stock Repurchases

There are three ways that a company can return money to shareholders. They can pay dividends, repurchase stock, and they can also liquidate the business. We will cover stock repurchases in this post. Lately, stock repurchases have become more popular. There are good and bad reasons for this. If a company pays a dividend, everyone will need to pay taxes. Stock repurchases can provide money back to shareholders in a tax free manner. Dividends benefit all shareholders proportionally. It's a bit different when a company repurchases stock. Only the shareholders who sell their shares back to the company receive money. The remaining shareholders then
hold a larger portion of the company, meaning they are entitled to a larger portion of the profits. Try this analogy. If you have a bank account with 100 dollars and pays 5% interest, what can change so that you make 6 dollars per year? The bank could give you 20 bucks for being a valued customer, which you decide to deposit back into your account. Your account with 120 will give you 6 dollars in interest (using your dividend to buy more stock), or the bank can raise your interest rate to 6% per year (market value of your asset stays the same, but generates more money for you).

Management should strive for a market price which is reasonably close to intrinsic value. This way, the owners will profit or lose based on the performance of the company, and not based on the time that they enter and exit. Warren Buffett has done a great job of this with Berkshire Hathaway. This is an arrangement of fairness. As partners in a company, you should not look to take advantage of each other in the event that someone might need to turn their ownership into cash for other purposes.

Given that it is often desirable to have the market value move closely with intrinsic value, there are a few things that can be done when they are drastically out of sync in order to benefit shareholders. We'll summarize them and then go into details. When the market value is much lower than intrinsic value, it is very beneficial to repurchase stock. When the market value is much higher than intrinsic value, it increases shareholder value to issue new stock. Dividends should be paid out if management cannot achieve a rate of return near the return of its core business. Dividends should be retained if management can deploy the resources into the business in a way that can earn a high rate of return.

The example that I will use is NFLX. I'd say the intrinsic value of NFLX is in the ballpark of around $50 to $55 per share. The market value is currently at $213 per share. I may not know what the intrinsic value of NFLX is, but I know that it's not $213. It's far less. To buy NFLX for $213 is the same as buying someone's quarter for $1, and then hoping that someone even dumber to come along to give us $2 for that same quarter. I rather be approximately correct than completely wrong. This is one of my favorite quotes from Warren Buffett. I may not know the exact intrinsic value of NFLX, nor may anyone, because intrinsic value is something that cannot be calculated as a science. But I know $50 to $55 is a far more accurate number than $213, which is completely wrong.

So the problem is here. NFLX has been repurchasing stock, as shown the bottom in page 9 of their 10-Q. They have been authorized to repurchase $300 million worth of NFLX stock between June 11, 2010 to the end of 2012. We also see that in the 3 months ending in June 30, 2011, NFLX has spent $51.4M repurchasing 216,000 shares at an average price of $238 per share. They've spent even more money in previous quarters. I find this to be outrageous. The bottom of page 4 shows 52,781,949 outstanding shares for Dec 31, 2010 and 52,536,264 for June 30, 2011. The bottom of page 5 shows that NFLX spent 160M issuing shares in the 6 months ending June 30, 2011. That means NFLX spent 108.6M in the first quarter. If we subtract the difference in outstanding shares, we get 52,781,949 - 52,536,264 = 245,685. This is only slightly larger than the 216,000 shares that was repurchased in the 3 months ending June 30, 2011. WHERE THE FUCK IS THE REST OF THE MONEY????? Did NFLX effectively spend 160M to repurchase the remaining 29685 shares? No, not quite, but you as might as well think that.

So here's what's happening. NFLX has issued many stock options to their employees. Let's pretend there is an option issued at a strike price of 1 dollar. When the employee decides to exercise his option, he pays $1 to NFLX, and receives a share of NFLX from the treasury. There will now be one additional share of NFLX outstanding in the market. If you look at the "Proceeds from issuance of common stock" on page 5, you notice that the money coming into NFLX is much smaller than the money going out of NFLX to repurchase shares. In order for NFLX to keep the number of outstanding shares constant, or slightly smaller, to show that they are actually using their money designated to repurchase stock to actually lower the outstanding number of shares, they forcefully overpay to repurchase NFLX stock. In our case, they paid $238 per share in the 3 months ending June 30, 2011. This results in a net loss of $237 to NFLX, and a gain of $237 to the employee exercising the option. The mystery of the missing money is now solved. Money spent on stock repurchases ultimately ended up as compensation in the hands of employees. To add insult to injury, the stock that NFLX bought at $238 is now at $213, providing the shareholders total loss of $237 + ($238 - $213) = $262 for this instance.  We can take this further and calculate the strike prices by looking into the Shareholder's Equity statement, but that won't be for now.

NFLX had 52.8M shares outstanding at the end of 2010. If they had paid out their $300M which has been dedicated to stock repurchase instead as a one time dividend, you would have received a little under $6 for each share that you own. When employees exercise their options, we would see the outstanding shares increase, which is far better than squandering the money by forcefully repurchasing NFLX stock at $238 per share.

Unfortunately, this does not stop at NFLX. In reasonable amounts, stock options and stock repurchases are a good way to incentivize employees as well as return money to shareholders. NFLX, as well as many other companies, are scamming shareholders out of their money. This scam allows these companies to put large amounts of money into the hands of their employees without showing that money as an expense on the income statement. This money is a real expense, and it is an expense to the shareholders. Now, don't get me wrong. I think it is a necessary evil to incentivize employees, especially if you are getting them to work for a startup with a sub par salary. They need to be able to justify their risk of working for a company that could go busto tomorrow. The scam is forceful purchase of stock at a ridiculously overvalued time in an attempt to hide the dilution. When a stock is as overvalued as NFLX, dilution is much more preferable to maintaining a low outstanding share count.

There is an incredible opportunity here to create shareholder value at the cost of taking advantage of new investors. I suspect that there are savvy finance departments which already do this. With a stock as overpriced as NFLX, you benefit the existing shareholders greatly by issuing more shares of stock. NFLX should sell more stock into the market at such an overvalued price of $238, and then quickly pay out the money that they receive as dividends. To visualize this, think of a company that has no revenues and expenses, or liabilities. Its only asset is a bank account of $50. (Think NFLX's intrinsic value) Let's say that you own the only share of stock to this company, entitling you to the full ownership of the bank account. If someone was foolish enough to pay $238 (Think NFLX's market value) for a share of stock, this company should issue one. Let's say it does. The company would now have 2 outstanding shares of stock, and $50 + $238 = $288 in its bank account. Then, pay a dividend of $94 per share. Each shareholder will receive $94, and the total amount of money the company now has is $100 after paying out the dividend. There are now 2 outstanding shares of stock, each with a 50% stake against a bank account of $100 dollars. The original shareholder has exactly what he started with, plus the $94 dividend. The second shareholder just got screwed. If you bought NFLX at $238, you are the second shareholder. NFLX bought 216,000 shares at $238. Shareholders of NFLX are all victims of such an action.

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