Editor's Choice

These Buybacks Are Terrible

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When companies announce share buyback programs, investors and analysts often applaud. But all buybacks aren't created equal, and many actually destroy shareholder value rather than create it.

Buybacks are a sign that a company believes that investing in its own stock is the best possible use of capital, and investors like to see this kind of confidence. But more often than not companies overpay for their own shares, sometimes taking out debt to do so, while better uses of the capital exists. And the proliferation of stock-based compensation clouds the benefits of buyback programs and reduces their effectiveness. Let's look at three companies that have genuinely terrible buyback programs.

No benefit at all

When a company is deciding how to allocate capital, the first choice should always be to invest back in the business. Only when this isn't feasible should companies turn to dividend or share buybacks as an alternative. But the price has to be right, and for fast growing companies this often is not the case.

Consider Chipotle (NYSE: CMG), for example. Chipotle is a fast growing company, with revenue growing by 20% and net income increasing by 29% in 2012. The company is building its store base rapidly, and capital expenditures greatly outpace depreciation. Does a buyback make sense for this company?

Chipotle has been buying back shares in modest quantities for years, with 2012 seeing $217 million worth of buybacks for the $11 billion market cap company. The company generated $223 million in free cash flow in 2012, so basically all excess cash is going to the buyback program.

Like many companies, Chipotle awards executives with stock-based compensation. In 2012 the value of this compensation totaled $64 million. What this means is that part of the buyback money actually goes to negating the dilution caused by the compensation. From the end of 2010 to the end of 2012 the share count actually increased even though the company spent $280 million on share buybacks. These buybacks, then, are a real cost that are required to prevent even further dilution of the share base. So even though the total free cash flow in 2011 and 2012 combined was $483 million, the true profits were just $203 million over that time, or about $100 million per year. The stock trades at about 100 times this figure.

Shareholders are receiving no benefit at all from Chipotle's share buyback program. In fact, the program is destroying shareholder value. The company is a whole lot less profitable than the commonly used figures suggest, and the stock should be avoided.

Are you Sirius?

Sirius (NASDAQ: SIRI), the satellite radio company, has a different problem that Chipotle. In December Sirius announced a $2 billion buyback program to the glee of many Sirius investors. But does it make any sense? Will it actually be good for shareholders? No, it doesn't and it won't.

Sirius is funding this buyback through cash on hand, the free cash flow, and taking out more debt. At the end of the first quarter Sirius had about $200 million in cash after spending $466 million on buybacks. The debt totaled $2.18 billion, on which Sirius paid $265 million of interest in 2012. Free cash flow in 2012 was $700 million, but Sirius paid no taxes due to a huge tax benefit. Sirius will need to take out more debt to complete the buyback, which is a seriously terrible idea.

Sirius's free cash flow per share is about $0.10. With a share price of about $3.50 the stock trades at 35 times the free cash flow, and that doesn't even factor in the debt. The message that Sirius is sending with the buyback is that buying its shares at 35 times FCF is a better investment than reducing its debt. The effective interest rate on that debt in 2012 was just shy of 10%, so it seems like a far better use of its cash and cash flow would be to pay off the debt instead of taking out more to buyback shares. If the company used the next three years worth of free cash flow to eliminate the debt it would increase profits considerably. This seems a lot more shareholder-friendly to me.

If a company takes out debt to fund a buyback, the stock better be seriously underpriced. This is not the case with Sirius, making the massive $2 billion buyback program a terrible idea.

Layoffs and ... buybacks?

A few days ago troubled game company Zynga (NASDAQ: ZNGA) announced that it was laying off 18% of its workforce. With revenue shrinking after years of rapid growth the company needs to cut costs, and these layoffs do just that. This announcement comes 8 months after the company announced a $200 million buyback program amidst weak earnings and falling revenue.

So here's a question: if the company is failing, with mass layoffs and consistent unprofitability, why in God's name is money being spent on a buyback? What does that accomplish? The focus should be to make Zynga a viable company, not to artificially boost the stock price. Zynga's business model is failing, and its push into online gambling is far from showing any real results. What is the management thinking?

Who would have thought that a business model revolving around free-to-play games wouldn't work? Oh yeah, everyone. The stock price may look cheap at around $2.80 per share, down from a post-IPO high of $14, but it's not. The company is valued at $2.2 billion, roughly twice annual sales. The company is sitting on $1.2 billion in cash and little debt, but as losses continue the company will likely need this money.

Another problem is the absurd levels of stock-based compensation. In 2012 the company awarded $282 million in stock options, a full 22% of the revenue. This has caused the share count to explode, and it will continue to explode as long as this practice continues. And now, with the stock price so low, retaining employees with the promise of stock options will be less effective.

Zynga is in trouble, and the idea that the company should waste money on a buyback is ludicrous. Investors should have been outraged by the announcement, not elated. Zynga is one of the least shareholder-friendly companies in the market today.

The bottom line

Some buybacks are good, with companies using excess cash to buy their own shares at a reasonable price. But some buybacks, like the ones highlighted above, do more harm than good. I'd avoid all three companies, as they care far more about boosting the share price than anything else. That's a recipe for disaster.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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