There are times when a corporation buying its own shares is an appropriate corporate investment, buy going into to debt to fund such buybacks, especially after a six-year bull market, is not one of them. From Wolf Richter at wolfstreet.com:
There may be a day when we look back at the current craze of “leveraged share buybacks” – as Fitch Ratings calls these creatures of financial engineering – the way we now look back at the craze of leveraged buyouts (LBO) just before it all came apart during the Financial Crisis.
If a company with a torrent of free cash flow uses some of this cash to invest and expand, and then uses some of the remaining cash to pay dividends and repurchase its own shares, few people would quibble with it.
The problem for bondholders, and stockholders ultimately, arises when a company doesn’t generate enough cash to pay for its investments, dividends, and share buybacks, and ends up borrowing to fund share buybacks, thus increasing its debt burden while hollowing out its equity capital.
Instead of investing this borrowed money to expand and create more business whose cash flow would help service that debt in the future, companies blow this money on reducing the number of shares outstanding, or at least watering down the impact of executive stock compensation plans. Nothing good ever comes of these “leveraged share buybacks,” other than making per-share metrics look better.
And that’s exactly what has been happening, encouraged by the Fed-inspired ultra-low interest rate environment, which makes debt cheap and creditors desperate.
According to the report, share buybacks have exceeded free cash flow after dividends (FCF) since 2014 among Fitch-rated companies, “with most companies using debt to cover the shortfall, underscoring a more aggressive stance across the sector.”
To continue reading: What Will Prick the “Leveraged Share Buyback” Craze?
