Buyback Baloney

By Daniel Kadlec

Wall Street has a way of taking a good thing and misusing it. Consider stock buybacks. For decades they were a comforting, surefire sign of management confidence. After the crash in 1987, hundreds of companies initiated plans to spend billions on their own dirt-cheap shares. That inspired investors to do the same and helped stanch the panic--a good thing. Today, though, buybacks can be more about funding management's stock options than about signaling its resolve.

Yes, plenty of companies still buy back shares for the right reasons. Deflated by the Firestone flap, Ford has increased and expedited a huge buyback unveiled last spring. The company plainly believes its woes are overblown, and many analysts agree. The stock is down 17% in two months and looks like a screaming bargain to some. I'm not so sure, given the bad publicity the Ford Explorer is getting.

Other companies announcing old-fashioned buybacks in the face of slumping shares include Sears and Nokia. And still others are engaging in buybacks as an alternative to paying dividends, sound from a tax view. Dividends are taxed as income; buybacks tend to lift a stock, which generates capital gains normally taxed at a lower rate.

Yet buybacks are increasingly concocted to offset the potential dilution of mega-stock-option grants, which exploded in number in the '90s. The strategy is especially prevalent among tech companies, including Dell, Adobe and Autodesk. But others, including Citigroup and Chiron, do it too. The idea is to buy back enough stock so that when executives and employees exercise options, the company can deliver the stock without printing more of it.

In a perfect match--say 100 million options exercised and 100 million shares repurchased--the all-important net effect on earnings per share is nil. But investors generally don't appreciate that. They see a huge stock buyback and assume it's positive because buybacks have traditionally reduced the number of shares outstanding, and that increased earnings per share and made each share more valuable.

Making matters worse, a lot of companies borrow funds to buy back shares, limiting their ability to invest in other opportunities and, increasingly, leveraging up to the point where their debt becomes riskier to the institutions that buy it. More risk requires more reward. So borrowing costs rise. This year Moody's has lowered the debt rating of 29 companies at least partly because of costly new buyback programs. All last year, there were just eight buyback-related downgrades.

Moreover, "about half of the high techs end up repurchasing stock near their highs," says Bob Gabele, who tracks stock-option activity for Thomson Financial Securities. That's hardly a wise use of cash. But companies fall into the trap because they've been doling out so many options for so long. They must buy back shares whatever the price--or issue more shares.

What does this mean to you? Not all buybacks are bullish. Look for one that takes place when the stock is depressed and the buyback is funded out of operations, asset sales or reserves. Ongoing buybacks can be good, providing a constant source of demand. But any buyback that merely offsets dilution from options should be dismissed as meaningless, possibly even harmful--unless you're the one with the stock options.

See time.com/personal for more on stock options. E-mail Dan at [email protected] See him Tuesdays on CNNfn at 12:20 p.m. E.T.