Do Buybacks Keep Party Crashers At Bay? Debt-financed buybacks on rise as takeover defenses By Daniel Del’Re 19 June 2006

Some companies use debt like sandbags to wall out corporate raiders. Natural gas producer Kerr-McGee did that in April 2005 when it sidestepped a messy proxy fight with billionaire investor Carl Icahn. Kerr-McGee soothed the self-proclaimed shareholder activist with a stock repurchase using almost $4 billion in new debt to mop up 27% of its outstanding shares. To pay back some of the debt, the company decided to sell its chemicals unit as well as some oil and gas properties. The buyback whipsawed Kerr-McGee's stock. It spiked 7% initially on the news. Trading volume surged. Icahn backed down. But Standard & Poor's slashed Kerr-McGee's credit rating to junk status. Investor euphoria faded within weeks, pulling the stock price below its prior level. Shares have since rallied to new heights on soaring energy prices. “It's very difficult to demonstrate that companies have increased shareholder value with buybacks using debt,” said Scott Wendelin, chief executive of Prospect Investment Advisors, which helps companies evaluate financial decisions. There's a moral to the story. Savvy managers should look before they leap into debt-financed buybacks. These maneuvers have short-term benefits. But the longer-term impact on corporate performance could be a mixed bag. Despite the risks, debt-financed buybacks are on the rise. The dollar value of planned buybacks rose about 6% worldwide from 2004 to 2005, according to Dealogic, which tracks corporate finances. Over the same period, debt financing dedicated to buybacks soared from $1.5 billion to $33.5 billion. The increase is significant even when factoring out the Kerr-McGee deal and a massive $22 billion debt-financed buyback from Procter & Gamble. In the first quarter of 2006, debt used for buybacks reached nearly $2 billion, 172% higher than a year earlier. Howard Silverblatt, an equity analyst with Standard & Poor's, expects the pace of debt-financed buybacks to accelerate as companies try to lock in relatively low interest rates.

The surge in debt-financed buybacks is part of a general expansion in stock buybacks of all types. Aggressive investors such as Icahn and saber-rattling hedge funds are pushing companies to buy back stock from shareholders as a way of giving them an immediate cash return on their investment. Also, Wall Street investment bankers are pitching buybacks as a defense against acquisitive buyout firms looking for acquisition targets. The impact on shareholders is unclear. On the plus side, debt financed buybacks can lower a company's overall financing costs because interest on debt is tax deductible. “If a company is paying a 40% tax rate and borrows at 6%, the real after-tax cost of debt is about 3.6%,” said Gordon Bava, a corporate lawyer with Manatt, Phelps & Phillips. "This is much less than equity investors typically seek in the way of dividends and capital appreciation." What's more, the obligation to repay debt prevents companies from spending like “typical teenagers,” said Michael Jensen of Harvard Business School. When debt is used for buybacks, says Jensen, companies rely more on debt to finance operations. This gives creditors more leverage to stop management from spending aggressively. But debt-financed buybacks can backfire just as easily. As with investing on margin, debt causes greater swings in investor fortunes; earnings per share and return on equity are bloated in boom times, but take the escalator down when sales fall. Also, credit rating agencies often downgrade companies for spending debt proceeds on nonrevenue generating transactions like buybacks. After a downgrade, companies pay more to raise money from investors and have less leverage to negotiate loan terms. Kerr-McGee's creditors, for example, claimed first dibs on proceeds from the sales of its chemicals unit, and limited additional borrowing. These restrictions limit a company's ability to invest in organic growth, like developing new products, expanding abroad or making acquisitions. Bava says companies also need to grow earnings through sales, not financial engineering like buybacks. In March, S&P expressed such concerns when CBRL Group, which operates Cracker Barrel and other restaurant chains, announced an $800 million buyback financed by $1.25 billion in new debt and the sale of its Logan's Roadhouse chain. S&P quickly warned of a downgrade to junk because of worries over the company's growth prospects.

“The magnitude of the share repurchase indicates that management doesn't see good investments for growth,” said S&P analyst Diane Shand. “At the same time, they're selling off an existing growth engine, Logan's Roadhouse.” Shand estimates that CBRL's buyback will bloat its balance sheet with debt 4.4 times greater than its most recent operating earnings vs. 1.9 now. Earnings must surge 230% to keep up with the increase in debt. The firm has provided no guidance on how that will happen without Logan's, says Shand. Another shareholder concern is the role of investment banks that advise companies on buybacks and financial decision making. They often earn more for financing loans than they do for transaction advice. Prospect Investment's Wendelin says this spurs bankers to encourage financing strategies requiring debt. For instance, Kerr-McGee's advisors, JPMorgan Chase and Lehman Bros., provided the debt for Kerr-McGee's buyback and advised the company on selling its chemicals unit to help repay the loans. Likewise, CBRL's advisor, Wachovia Securities, provided the entire $1.25 billion in debt and advised the company on selling Logan's Roadhouse. Kerr-McGee's CFO Bob Wohleber says the debt was justified, as cash flow was adequate to cover expansion projects. CBRL and Wachovia declined to comment when asked what alternatives to debt-financed buybacks were considered. “It's clear that the potential for conflict is enormous,” said Pat McGurn, executive vice president of Institutional Shareholder Services, a shareholder advocacy group. “Board directors really need to sit down and run the numbers (on the transactions being proposed) to make sure they're not going to get railroaded.” Nevertheless, investors are setting the stage for more debt-financed buybacks. They continue to favor buybacks of all flavors and are more tolerant of debt even at the risk of a credit downgrade. Take newspaper publisher Tribune Co.. Its shares surged 7.2% two weeks ago after announcing plans to borrow $2 billion to repurchase 25% of its shares, despite a possible credit downgrade from Fitch and S&P. Analysts say the move’s designed to stop acquirers. “If you don't have significant leverage today, there's the perception that you're not doing your job to enhance shareholder value,” said King Penniman, president of debt research firm KDP Investment.