Share Buybacks That Pay Back In Spades

Hedging techniques are earning millions in tax-free income for savvy companies

Thousands of companies have gone into the stock market in recent years to buy back billions of their own shares. But perhaps only 100 or so have turned to savvy hedging techniques that help execute those buybacks--and earn tax-free millions to boot. Dell Computer Corp. has saved itself about $1.6 billion in the last two years. Microsoft Corp. reaped $600 million in the past three-and-a-half years. Smaller fry are playing too: Appliance-maker Maytag Corp. netted $10 million over the past year.

Just how often these techniques are used is hard to say. Most companies don't trumpet the deals. In some cases, evidence of the transaction shows up as an entry on the balance sheet and in the company's financial statements. Among the companies that have used these techniques are Boeing, IBM, Intel, and McDonald's.

PRIVATE CONTRACTS. But perhaps even more often, these buyback-related transactions never see daylight: They are private contracts between companies and their investment bankers, and the rules require that companies disclose them only if they are "material"--and that's a judgment call the company makes itself.

By all accounts, this sort of dealmaking will be on the increase as companies continue to repurchase shares even at today's high prices. Under new accounting rules, companies must also report their income as though the stock options they have granted over the years had been exercised. That means diluting today's income over more and more shares. The only way to offset that is to reduce the number of shares outstanding. Companies can reduce their shares just by buying in the market.

But there is often a better way. Microsoft's millions come from selling "put warrants" in conjunction with its share repurchase program. In such a transaction, the seller gives the buyer, usually an investment bank, the right to sell shares of the company stock to the company at a predetermined price, called the strike price. This right has a finite life, say, 12 months.

For this right, the buyer pays the seller a fee or premium. For instance, for a stock selling at 40, a one-year put warrant with a strike price of 40 might sell for about $3 per share for 1 million shares (table). That $3 million is free and clear to the issuer since the tax code allows corporations to sell options on their stock tax-free. "It's one of the few sources of cash that isn't ultimately taxable," says Robert Willens, tax and accounting analyst for Lehman Brothers Inc. "That's what makes put warrants so attractive."

If the stock takes off and the price at expiration is above the strike, the put will expire worthless, and the premium is pure profit. True, it will cost the company more to buy the stock in a rising market, but the company can use that premium to offset the somewhat higher cost. "This is not a substitute for a share buyback program," says Christopher Innes, a managing director at NationsBanc Montgomery Securities Inc. "But if a company has already decided to buy back its stock, why not get paid for that decision?"

Indeed, Microsoft has been paid in spades. The company has sold 30 million to 40 million puts a year, and not one share has been "put" back to the company. Microsoft sells puts on a continuous basis, timing the sales to each year's buyback plan and staggering the expirations. All together, Microsoft now has about 23 million put warrants outstanding. "This strategy makes all the sense in the world for successful technology companies," says Gregory B. Maffei, Microsoft's chief financial officer. "They're cash rich and face tons of employee stock options."

What if the company is wrong about its stock's prospects, and the shares head south? Should shares trade below 40 at expiration, the warrant is "in the money," and the investment house will put the warrant back to the company--that is, force it to buy shares at 40. So if the shares are at 38, the company pays $2 a share over the market price, a loss offset by the $3 a share it earned on the premium. Of course, if the price is below 37, the company's position is a net loss.

LOST OPPORTUNITY. "You win if the stock goes up, and you win if the stock goes down a little," says Eric B. Lindenberg, a managing director at Salomon Smith Barney. "But if the stock goes down a lot, you forgo the opportunity to buy at a much lower price." In selling puts, the company is committing itself to buy the stock at the strike price when the put expires.

If the deal is so sweet for the company, what's in it for the likes of Salomon and NationsBanc? In buying the warrants, the bankers have to lay out cash for the premium. The investment house doesn't want to be caught with a worthless warrant either, so they hedge the warrant by buying the company's shares in the open market. But they don't have to buy one for each warrant. Using a sophisticated hedging model, they figure they can hedge, say, 1 million warrants with 400,000 shares.

So how does the investment bank make money? If the stock goes up, the warrants look more and more like losers. But as the stock rises, the put owner needs fewer shares to hedge the position. So the investment firm sells some stock into the open market and realizes some profits. If the stock winds up below the strike, the investment bank collects $40 per share no matter how far the price falls.

Some companies take the put-buyback technique a step further. Dell Computer considered selling puts when it launched a buyback program two years ago. But Dell executives wanted to lock in a price for the shares they needed to buy rather than relying just on put premiums to offset some of the cost.

So Dell set up a "collar." It sold puts, then took the premium and bought calls. The calls gave Dell the right to purchase a set amount of shares at a fixed price. So, as Dell's stock soared past the calls' strike prices--it's up more than 1000% since the buyback program began in February, 1996--the company locked in shares on the cheap. What's more, the calls allowed it to buy shares it might not otherwise have been able to afford. Though the company is flush with cash now, it wasn't when the buyback began, says Dell Treasurer Alex C. Smith.

In all, Smith says the company repurchased 68 million shares at a split-adjusted price of 20. The average price of the stock during that time was 43, according to Bloomberg Financial Markets. BUSINESS WEEK estimates Dell's savings at about $1.6 billion.

STAR PERFORMERS. Of course, the reason the buyback programs at Microsoft and Dell fared so well was that the stocks were star performers. That's not always the case. A few years ago, biotech giant Amgen Corp. tried the collar approach as well--but its stock went nowhere, and both the puts and calls expired worthless. Then, with the stock around 50, Amgen Treasurer Larry May says the company sold puts at strike prices in the high 40s. "We believe our stock is cheap and would not mind buying it at those levels." Amgen is now at 54.

Until now, the big investment banks have dominated the put end of the business, customizing options to each client's needs. Now, the Chicago Board Options Exchange, the largest options exchange, is making a push for the business as well. William Barclay, CBOE vice-president, says the exchange will soon get the regulatory clearance to offer more competitive options with more flexible terms. Until then, it's the big boys' game.

There's no question the put-buyback technique and its variations work best when a company's stock is on the rise. With the bull kicking up the dust again, more and more companies will be looking for ways to save money on their buyback plans. And the list of savvy companies is sure to get longer.

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