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.

18 comments

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“But in reality shareholders take out much more than they put in.”

ummm. yeah – isn’t that the goal? shareholders put in some money, take out a lot more money… kinda like the stats show??? isn’t all that money taken out (in excess of money in) the value that was created? Isn’t that the same as the preceding sentence:

“Shareholders like to think of the stock market as a place where they fund companies with equity, take risks, and then reap returns.”

Posted by KidDynamite | Report as abusive

NYSE:TR has been doing “scrip dividends” for a while, though I’ve not heard them called that before; I typically hear it called a “stock dividend”, though that can be unclear to people who aren’t familiar with the idea (who might simply think you mean a dividend that a stock pays, rather than a dividend paid in stock). Google and Yahoo Finance both report annual 103:100 stock splits, but it’s treated differently for tax purposes for the company and the shareholder as well as accounting purposes for the company.

Posted by dWj | Report as abusive

Homework assignment: rewrite this article about, say, Advance Auto Parts and see if you come to the same conclusion. Discuss.

Posted by loudnotes | Report as abusive

While I agree with your summary – Dell wasted a lot of money, there are some statements that are flawed.

“shareholders take out much more than they put in”
“And all the extra money went to fickle shareholders who sold their stock back to the company.”

Shareholders aren’t selling their shares back to Dell, they are selling them on the open market, and Dell happens to be a buyer. They aren’t taking money out of Dell, any more than if I sold you my shares. And why are the shareholders fickle? What if they no longer believed in the ability of Dell’s management to run the company competently?

“In theory, shareholders who want income will sell some percentage of their shares back to the company and get income that way,”

There’s this thing called the “stock market”, where people can buy and sell shares in publicly traded companies, even if the company isn’t buying or selling shares. Buybacks aren’t necessary for this function.

“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”

This assumes demand is sticky and not transient, and that over the course of a year, there would be the same amount of sellers and buyers whether or not Dell was buying shares. Which is not a safe assumption.

” I quite like buybacks over dividends: they’re a way of returning cash to shareholders, without sticking those shareholders with possibly-unwanted income.”

The primary purpose of a corporation is to enable multiple shareholders, who share in the profits; allowing people to speculate on whether a company will grow faster than the population is a side effect. If you don’t want to receive earnings, buy a less mature company. But you already know that Dell is not a growth company, and should be viewed as an income generator, not a growth engine.

Posted by KenG_CA | Report as abusive

NYSE:TR has been doing “scrip dividends” for a while, though I’ve not heard them called that before; I typically hear it called a “stock dividend”, though that can be unclear to people who aren’t familiar with the idea (who might simply think you mean a dividend that a stock pays, rather than a dividend paid in stock). Google and Yahoo Finance both report annual 103:100 stock splits, but it’s treated differently for tax purposes for the company and the shareholder as well as accounting purposes for the company.

Posted by dWj | Report as abusive

Would be interested to know. Do US companies issue scrip dividends ever? I have no clue myself.

But it’s not something I’ve really heard of while it’s quite common in London as you say.

If US companies don’t I wouldn’t be surprised to find out that it’s a difference of tax treatment that explains the difference (that difference that I don’t know exists).

Posted by TimWorstall | Report as abusive

While I agree with your summary – Dell wasted a lot of money, there are some statements that are flawed.

“shareholders take out much more than they put in”
“And all the extra money went to fickle shareholders who sold their stock back to the company.”

Shareholders aren’t selling their shares back to Dell, they are selling them on the open market, and Dell happens to be a buyer. They aren’t taking money out of Dell, any more than if I sold you my shares. And why are the shareholders fickle? What if they no longer believed in the ability of Dell’s management to run the company competently?

“In theory, shareholders who want income will sell some percentage of their shares back to the company and get income that way,”

There’s this thing called the “stock market”, where people can buy and sell shares in publicly traded companies, even if the company isn’t buying or selling shares. Buybacks aren’t necessary for this function.

“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”

This assumes demand is sticky and not transient, and that over the course of a year, there would be the same amount of sellers and buyers whether or not Dell was buying shares. Which is not a safe assumption.

” I quite like buybacks over dividends: they’re a way of returning cash to shareholders, without sticking those shareholders with possibly-unwanted income.”

The primary purpose of a corporation is to enable multiple shareholders, who share in the profits; allowing people to speculate on whether a company will grow faster than the population is a side effect. If you don’t want to receive earnings, buy a less mature company. But you already know that Dell is not a growth company, and should be viewed as an income generator, not a growth engine.

Posted by KenG_CA | Report as abusive

Re: dividends versus buybacks, as you’ve observed yourself, if you get a dividend you can immediately reinvest, just as with the buyback you can decline to take it. They’re almost-equivalent; the difference is only in the default — with a dividend, if you haven’t opted-in for reinvestment, and you don’t go out and spend the dividend on a purchase, you end up with income. With a buyback, you have to choose to go sell some shares.

I agree with you that it’s absurd to claim you’re spending on growth when you’re actually distributing money to shareholders, whether through a buyback or a dividend.

A “scrip dividend” (which I guess must be equivalent to what we Yanks call a “stock dividend”) is not a payout at all. It’s a split at a non-integer multiple. One share becomes, say 1.05 shares, and the stock price gets multiplied by the reciprocal of 1.05. Unless there is a new influx of money on the demand side — e.g. the company is putting up cash to buy some of the new shares — if a bunch of stockholders decide they want to cash out their 5% dividend shares, they’re going to drive the price down even further. A stock dividend does not distribute cash to shareholders.

Now, if you actually think Dell had some great internal growth opportunities to invest in, then maybe that would’ve been a good thing — maybe they should’ve dumped that cash into R&D, or something. But as Matt Yglesias says, innovation is really hard. Maybe Dell was absolutely right that it was better for them to distribute cash. And maybe the investors who bet against them on that point — whether buy reinvesting dividends or refusing to take part in the buyback program — were wrong.

One last thing: on your statement that Dell spent all of the money from its earnings, and then some, on stock buybacks — is that right? You haven’t given the numbers you’d need to, to assert it. I suspect it probably is correct; in the most recent few years, going backward, they reported around 3.49, 2.64, 1.43, and 2.48 billion in earnings… But over the 15-year window, maybe they had some really inflated numbers in ’98-’00. So I’d want to see the actual total earnings number for the past 15 years, not just EPS, to be sure. (Or I suppose you could take each buyback period, divide the spend for that period by the number of shares at the beginning of the period, and sum those up, to get a buyback-spending per share figure to compare to the EPS figure. But that seems like a lot more work.)

Posted by Auros | Report as abusive

sorry about the duplicate comments – am I the only one having trouble submitting them? It doesn’t show the comment, and it says it’s waiting for the reuters server to respond. After trying several times, I used a different browser, and then the original comment showed up. twice.

I think Reuters should have taken advantage of the 2-week shutdown and revamped the comments section.

Posted by KenG_CA | Report as abusive

NYSE:TR has been doing “scrip dividends” for a while, though I’ve not heard them called that before; I typically hear it called a “stock dividend”, though that can be unclear to people who aren’t familiar with the idea (who might simply think you mean a dividend that a stock pays, rather than a dividend paid in stock). Google and Yahoo Finance both report annual 103:100 stock splits, but it’s treated differently for tax purposes for the company and the shareholder as well as accounting purposes for the company.

Posted by dWj | Report as abusive

Felix,
The simple fact is that a company buying back stock with a declining price looks bad and vice-versa.

Once you have run out of the need for growth capital – i.e. maturity – you need to choose how to remunerate shareholders – divs or buyback.

Often for shareholders their preference comes down to tax issues – witholding and income on divs, capital gains on buybacks.

Scrip is just BS. That isn’t returning capital.

Of course a mature business should be able to return ALL earnings to shareholders. But to say a company’s share price should be equal to the sum of the previous 10 years’ earnings is perhaps the weirdest valuation metric you have come up with yet!!

At maturity stock price = NPV of future earnings.

Would you like to buy some Nokia???

Posted by TinyTim1 | Report as abusive

One of the big reasons you see so much buyback in tech is to limit the dilution from options issuance. Dell issued millions of options in the 90′s, and a good portion of their buybacks had to be absorbing the shares that were created when options were exercised. From that pov, the buybacks were a way to compensate employees. Options were not considered expenses for the 1997-2012 period where most of the options were issued. So you have this non-expense expense absorbing the profit that should go to long-term shareholders but doesn’t.

Account for the number of options exercised, back out those costs, and re-calculate the cumulative earnings for that period.

Posted by winstongator | Report as abusive

@Auros – winstongator’s comment bears on your point. To the extent that Dell employees were exercising options, Dell’s net spending on its buyback also looks a lot smaller, since it was receiving cash from employees who exercised options.

Regarding dividends, many large companies have dividend reinvestment programs that allow shareholders to reinvest dividends automatically into share purchases of the company. It is true that taxes have to be paid on the dividend, though that’s really just a question of timing of how long taxes are deferred since the dividend rate and LT capital gains rates are currently the same.

Posted by realist50 | Report as abusive

@Auros – winstongator’s comment bears on your point. To the extent that Dell employees were exercising options, Dell’s net spending on its buyback also looks a lot smaller, since it was receiving cash from employees who exercised options.

Regarding dividends, many large companies have dividend reinvestment programs that allow shareholders to reinvest dividends automatically into share purchases of the company. It is true that taxes have to be paid on the dividend, though that’s really just a question of timing of how long taxes are deferred since the dividend rate and LT capital gains rates are currently the same.

Posted by realist50 | Report as abusive

@Auros – winstongator’s comment bears on your point. To the extent that Dell employees were exercising options, Dell’s net spending on its buyback also looks a lot smaller, since it was receiving cash from employees who exercised options.

Regarding dividends, many large companies have dividend reinvestment programs that allow shareholders to reinvest dividends automatically into share purchases of the company. It is true that taxes have to be paid on the dividend, though that’s really just a question of timing of how long taxes are deferred since the dividend rate and LT capital gains rates are currently the same.

Posted by realist50 | Report as abusive

Felix, this is just a fancy way of saying that when you hold a stock with a P/E over 30 that you should expect to lose money. Their net income increased by 50% from 2003 to 2012, their shares outstanding fell. But there is almost no level of growth which will defend against a P/E retrenchment from 40 to 6.

For a while in there their share count wasn’t decreasing much at all. Now they are repurchasing quite aggressively, and at a bargain valuation. If they can maintain their current cash flow, buyers at the current price will be richly rewarded.

Then you get to HP, with a share repurchase program SO strong that their revenues and cash flow can contract significantly and STILL grow on a per-share basis.

Conclusion — you get much more bang for the buck when buying at a 6 P/E than a 60 P/E. At least you do if the company doesn’t die.

Posted by TFF17 | Report as abusive

ERA of the PC is over. Unless Dell believes it holds some competitive advantage(it does not) it should operate the company as a liquidating trust , invest only what’s necessary to maintain the product and return everything else to the shareholders.

Posted by Sechel | Report as abusive

Michael is restless and it’s easier to game doubling the price to the new private equits without the public baggage.

Posted by HiOnow | Report as abusive