Individuals shouldn’t go into debt to buy stock. Neither should companies, even if it’s their own stock.
Try telling that to corporate America, which is increasingly turning to debt to fund stock repurchases.
So far this year, according to JP Morgan , 37 companies have announced plans to spend $39 billion in debt-funded stock repurchases. Many more, taking advantage of low-interest rates to re-lever their balance sheets, will likely lump in stock repurchases as “general corporate purposes”—cited as the use of proceeds in many debt deals.
Using debt or stock, buybacks are controversial. All too often companies buy stock at what appeared to be low prices only to see the shares sink further. Other times, the buybacks are announced to juice the stock, but never carried out.
What’s worse, some investors view even debt-financed stock buybacks as a form of returning cash to shareholders—except, it isn’t!
Just as a company wouldn’t borrow to pay a dividend, it also shouldn’t borrow to buy back shares.
In my ideal world, shares, if they’re to be repurchased, should be bought with extra cash—and then because it genuinely is the best use of cash.
I’m not the only one who feels this way. In fact, Fitch downgraded Amgen in part because of its plan to use debt to buyback stock.
In a note Tuesday Fitch took it a step further (emphasis by me):
Recent share repurchase announcements among U.S. corporate issuers have turned decidedly more aggressive, according to Fitch Ratings.
Until recently, share repurchases were completed primarily out of free cash flow, as companies felt comfortable in the level of cash on hand, leverage, and maturity schedules. There has been a pronounced trend more recently to heavy shareholder repurchase plans that result in a re-leveraging of the companies, and often lower debt ratings.
Share repurchases often signal problems in the underlying business: Whether due to a slow-growth environment, competitive pressures, product-cycle issues, or simply weak operating execution, lagging return-on-equity performance is often a catalyst for more aggressive financial engineering. The combination of these factors, together with higher leverage resulting from large share repurchases, could portend further long-term credit deterioration beyond the initial re-leveraging.
This is part of the explanation why share repurchase programs have such an abysmal track record of capital utilization.
Investment-grade companies most at risk: This is largely the case simply because these companies often have the luxury of focusing on shareholder returns, even in an uncertain environment, as adequate liquidity and positive free cash flow may be more than sufficient to weather a protracted period of economic weakness.
Retail sector has demonstrated a higher risk: With a slow-growth environment and the growth in internet shopping, business models and competitive pressures have weakened operating results and accelerated capital restructuring options. Companies include Radio Shack and Best Buy .
Stealth repurchase programs also a risk: Companies may also accelerate share repurchase programs under previously authorized programs that may have remained somewhat dormant due to the uncertain macro environment, but which may come back to life without the fanfare of announcing a new program.
Not all share repurchase plans are painted with the same brush: A distinction remains between returning excess cash to shareholders and financial engineering. Share repurchase plans can be part of a consistent capital structure strategy, with excess cash generation being returned to shareholders and stable credit metrics.
The jump in new, heavy programs, generally do not fall into that category, and remain at risk of further deterioration in operating results and financial leverage.
I rest my case.
Questions? Comments? Write to HerbOnTheStreet@cnbc.com