Stock Buybacks Are Back With A TwistPhillip L. Zweig
Amid the scare talk about the dangers of derivatives, a small but growing list of big U.S. companies is quietly using them to cut their costs of stock repurchases--so far, without apparent harmful side effects.
Stock buybacks are nothing new, of course. For years, companies that considered their stock a bargain have repurchased shares. This year, the number of announced buyback deals is running at the highest level since 1990, according to Securities Data Corp.
Something new has been added. Growing numbers of sophisticated companies are benefiting by repurchasing their stock, while at the same time selling put options to investment banking firms giving them the right to redeem their shares in the future at a predetermined "strike price." This strategy, treasurers say, typically results in a lower average cost per share to the company than if it had simply bought the shares back the traditional way. At least one company has reaped a windfall of more than $100 million--tax-free.
"UNCOMFORTABLE." Although there have been no known heavy losses or other snafus involving put options in buyback programs, derivatives have become so sensitive a subject that only a few companies--notably Intel Corp. and WMX Technologies Inc.--disclose using the technique in public filings. Others, including Hercules Inc. in Wilmington, Del., and Mobil Corp., are known to be using puts but do not disclose it. Spokesmen for the two companies declined to comment.
W. Bradford Hu, vice-president for equity derivatives at Morgan Stanley & Co., one of about a half-dozen big firms that buy these options, estimates that while only about two-dozen U.S. companies have gone the put-option route, "a couple of hundred" could benefit from using them. Some financial officers, he says, "resist using put options in buyback programs because of the fear that the CEO might be uncomfortable with it," says Hu. "It's sometimes a long education process to get him comfortable."
The arrangement works this way: A company whose stock is trading at, say, $25 sells put options at $3 per share, giving the holder the right to sell shares to the company at $24 a share when the options expire three months later. If the stock price remains steady dr rises--say, to $28--the options expire, and the company pockets the cash. Since companies, under tax and accounting rules, are not allowed to treat premiums from stock-related transactions as earnings, they can record the transaction as a tax-free credit to cash and equity. If the price falls to, say, $22 a share, the holder will likely exercise his option, selling shares to the company for $24 each. Considering the $3 option premium, the company's effective cost is $21 a share, $1 cheaper than the $22 market price.
There's a downside to the technique. If the shares fall substantially, the company's effective cost would exceed the stock price. For example, if the price fell to $10 and the company had to repurchase the shares from option holders at $24 instead of $10, the company, treasurers acknowledge, would obviously have egg on its face. But they argue that as long as they were prepared to repurchase the stock at $25 per share in the first place, the missed opportunity would be bearable.
The investment-banking firms that buy the options aren't doing it merely to accommodate repurchase clients--they expect to make money on their positions. Experts say they would face serious risks only if share prices remained stagnant for a long period of time.
CLEANING UP. One of the first companies to do option buybacks was Intel, the Santa Clara (Calif.) microchip maker. Since 1990, when it first sold put options in connection with a buyback offer, it has raked in $183 million in premiums. Indeed, Intel fits the profile of a company most likely to benefit from such a program. Besides its rapid growth, its stock has been exceptionally volatile, which attracts option buyers. On its way from a share price of about $20 in early 1990 to its close on Aug. 17 at 633/4, Intel stock has suffered some short-term setbacks. Says Treasurer Arvind Sodhani, who initiated the program: "Volatility creates value. Your stock has to have a certain amount of volatility or the premiums aren't going to be of a size that would make a difference."
Since WMX Technologies, an environmental cleanup company in Oak Brook, Ill., began using the technique earlier this year, it has added $15 million to its coffers, according to Bruce D. Tobecksen, vice-president for finance. Few companies, though, disclose their use of option buybacks in public financial statements. Charles S. Whitman III, a securities lawyer with Davis Polk & Wardwell, says that while companies are required to disclose sizable buyback programs, "they're not required to announce the mechanics involved."
Morgan Stanley's Hu says recent tax-law changes that favor capital gains over dividend income for individuals will likely trigger more buyback offers. And he adds that using put options could become more popular as financial officers become increasingly familiar with them. If that happens, more users might find it safe to come out of the closet.