The problem with buybacks, Dell edition

By Felix Salmon
September 4, 2012

Fifteen years ago today, on September 4, 1997, Dell stock closed at $86.69 per share; on a split-adjusted basis, that works out to $10.84 per share today. The stock peaked at almost 5 times that level, in March 2000, but it’s not looking quite so hot any more: it’s now back down to $10.52 per share.

Over the course of the intervening 15 years, Dell has been solidly profitable, and in fact reached record earnings per share of $1.87 in 2011. It has never had an unprofitable year, and the company’s total earnings since 1997 (if you exclude 1997′s earnings but include the $1.68 in 2012) total $15.40 per share.

How is it possible that Dell has earned more than $15 per share since 1997, has never lost any money, has never paid a dividend, and is now worth less than $11? The answer, of course, is buybacks:

Based on their annual 10K filings, from Fiscal Year 2005 to 2012, Dell has purchased approximately 989 million of its own shares at a cost of over $24bn… Going back further to 1997 (through February 3, 2012), Dell has reportedly spent approximately $39 billion in share repurchases under a $45 billion repurchase program.

$39 billion is more than double Dell’s current market capitalization of $18 billion, and it’s over a thousand times more than the $30 million that Dell actually raised from the market in its 1988 IPO.

Dell, then, is an extreme example of a phenomenon that is actually typical of the market as a whole, which has seen net equity issuance of negative $287 billion in just the past ten years — and that’s not even counting dividends. Shareholders like to think of the stock market as a place where they fund companies with equity, take risks, and then reap returns. But in reality shareholders take out much more than they put in.

Every company says it wants buy-and-hold shareholders, who will stick with the firm for the long term. But a buy-and-hold shareholder in Dell is looking particularly idiotic right now. If you bought 15 years ago at $10.84, you should expect to have at least $15.40 in value at this point: after all: that’s how much the company has made since then. Instead, you have less than you started with. And all the extra money went to fickle shareholders who sold their stock back to the company.

In principle, I quite like buybacks over dividends: they’re a way of returning cash to shareholders, without sticking those shareholders with possibly-unwanted income. In theory, shareholders who want income will sell some percentage of their shares back to the company and get income that way, while shareholders who don’t want income will see the value of their shares rise, thanks to the fact that there’s extra demand in the market and the fact that the free float is shrinking.

In practice, however, as we can see with Dell, it doesn’t always work that way. The company ends up overpaying for its shares when the stock is high, thereby essentially taking money which belongs to all shareholders, and distributing it only to those who are exiting. As a result, the most loyal and faithful shareholders can end up with less than they started with, even when the company has been solidly profitable all along.

If things were sensible, a company could simply declare a dividend, and then the investors who didn’t want the income could just reinvest that dividend back into the stock. In the UK, we have things called scrip dividends which serve that purpose*: you basically get your dividend paid in stock rather than cash. If you want to sell that stock and take the dividend you can, but if you don’t, you don’t have to.

If Dell had gone for a scrip dividend rather than buybacks, then at least our hypothetical 1997 buy-and-hold investor would have more stock now than she had originally, and the past 15 years’ profits wouldn’t have disappeared into the pockets of the lucky few who sold high on the secondary market. Those people would still have made money on the movement of the stock; they just wouldn’t have taken profits from other shareholders.

As for Dell’s statement, justifying its lack of a dividend, saying that “our earnings are best utilized by investing in internal growth opportunities, such as new products, new customer segments and new geographic markets” — well, it doesn’t pass the laugh test. Dell has spent all of the money from its earnings — and then some — on stock buybacks, rather than on new products or new markets. And stock buybacks are never an “internal growth opportunity”.

(h/t Elfenbein)

*Update: Many commenters, along with jdpink, have pointed out that scrip dividends are basically just fractional stock splits, and don’t return any cash to shareholders. From a behavioral-econ perspective, shareholders might be more willing to sell their scrip to get a dividend check than they are to sell some percentage of the shares that they hold in a non-dividend paying stock. But unless the scrip dividend is optional, it doesn’t get cash off a company’s balance sheet. And if it is optional, then the new shares count as income for tax purposes.

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