Financial Engineering Continues Unchecked – Stocks Love
by the Curmudgeon with Victor Sperandeo
We continue to maintain that various types of financial engineering are the primary drivers of the bull market in U.S. equities. This corporate chicanery is made possible, encouraged, aided and abetted by ultra-low financing rates and misguided U.S. corporate income tax policies. We've detailed the endless share buybacks, mergers & acquisitions (especially of start-up companies), hiding profits off shore to avoid taxes, accounting gimmicks, etc. in many past Curmudgeon posts.
Let's examine what happened this past week in this contentious area. We first look at proposed legislation to curtail corporate "inversions" along with an analyst's comment on the stock market dismissing that potential threat to end the practice. Next we highlight how a new share buyback announcement trumped disappointing sales, earnings, and forward guidance at Polycom. Caterpillar's huge buyback was cheered by the market, even though sales were flat and have been declining for 19 months (see chart). Expert opinions are presented on the long term effects of share buybacks. Lastly, Victor weighs in with his comments on the real purpose of capital markets.
Legislation Proposed to Stop Corporate Inversions Stalls:
Last week, U.S. Treasury Secretary Jacob Lew threatened to put an end to the wave of "inversion" strategies being used by pharmaceutical and other companies to acquire a foreign company to gain tax benefits. Mr. Lew suggested any new law to end this practice be made retro-active. While he called for quick action, the NY Times reported that "the Obama administration and Congress appear unlikely to take any action to stem the tide of such deals anytime soon."
The public focus on corporate inversions began this past April, as the pharmaceutical giant Pfizer made a bid to merge with a smaller foreign company and then call itself a foreign corporation for tax purposes. The drug store chain Walgreens announced that it was considering doing the same. These were followed by the medical device maker Medtronic and the pharmaceutical companies Mylan and AbbVie.
"This inversion loophole must be plugged,” Senator Ron Wyden, Democrat of Oregon and chairman of the Senate Finance Committee, said in a statement. “As the speed of inversions increases, this will only fuel bipartisan urgency to stop companies from deserting the U.S. I’m talking with my colleagues and exploring options for addressing this in the near and long term,” he added.
A Senate Finance Committee hearing this past Tuesday, Mr. Wyden described inversions as a “plague,” and called for retroactive legislation that would eliminate substantial tax benefits of many of the cross-border deals announced over the last year. Deals including Medtronic’s proposed acquisition of Covidien, and AbbVie’s agreed deal to acquire Shire, among others, would be affected by retroactive legislation.
“The inversion virus now seems to be multiplying every few days,” Mr. Wyden said. “The underlying sickness continues to gnaw away at the American economy with increasing intensity.” But there was no consensus on how to address the issue in Congress.
Paul Macrae Montgomery of Universal Economics notes that the market has shrugged off Congressional attempts to stop or slow down corporate inversions.
[That's nothing new! The market seems to ignore or dismiss any negative news (e.g. GDP revised down to -2.9%) and threats to corporate earnings (e.g. bad economic reports, geopolitical hostilities, declining profits, profit margins and productivity, gridlock in Washington short circuiting any fiscal policy, etc.)]
In a July 21st note to subscribers, Mr. Montgomery wrote: "In our experience, if a news item like this is going to affect the market, it usually does so within 48 hours after its release. The lack of a market response to this "ham fisted" initiative indicates that the boom in corporate adventurism is not about to go bust."
"The long term implications of the current deal activity are bearish, but that's a story for another day. As of today, corporate action should continue to have a positive intermediate term effect on stock prices," he added.
Share Buyback Magic:
A superb example of Wall Street's love affair with share buybacks (and how that "magic" trumps sales or earnings) was illustrated this Thursday July 24th by Polycom Inc. (PLCM) -- a maker of unified communications (mostly video conferencing) equipment and software. The company posted disappointing financial results for the second quarter of 2014 as both the top and the bottom line fell below the respective Zacks consensus estimates.
· GAAP net income in the second quarter of 2014 was $8.6 million or 6 cent per share compared with $5.3 million or 3 cents per share in the prior-year quarter. That was way below Zacks consensus estimate of at 14 cents per share.
· Total revenue in the second quarter came in at a little over $332 million, down 3.8% year over year and $8 million below the Zacks consensus estimate of $340 million.
Despite the earnings and sales misses along with lower forward guidance, PLCM stock was up 6.2% on Thursday due to a new $200M share buyback. The company also said it completed its previously announced $400 million Return of Capital program.
“Today’s announcement illustrates our confidence in the long-term growth of the company and our continued commitment to returning capital to shareholders,” said Laura Durr, chief financial officer of Polycom. “We expect to execute this new $200 million authorization over the next two years, while retaining sufficient capital capacity to continue making long term investments in our business and to pursue strategic opportunities that may arise.”
That's all the market needed for PLCMP stock to pop on July 24th. Polycom has returned $537 million to shareholders through share repurchase over the last two years. Evidently, the market loves that more than organic growth in the company's business, which hasn't happened.
Here's another share buyback smokescreen example: Caterpillar (CAT) announced a new plan to buyback approximately $2.5 billion worth of shares during the third quarter, despite flat sales that are way below Nov 2012 levels.
"After a sizable drop in sales and revenues in 2013, our ongoing forecasting process has, since the third quarter of last year, pegged 2014 as a roughly flat year for sales. That's still the case," said Caterpillar CEO Doug Oberhelman. On the huge buyback, he said, "With a strong balance sheet, positive cash flow, sufficient cash on hand and more modest needs for capital expenditures, it makes sense to continue to reward stockholders."
Tyler Durden of Zero Hedge had a different take on CAT:
“Earlier today, Caterpillar reported its monthly global OEM retail sales. It didn’t get any press coverage for one simple reason: Through stock repurchases, Caterpillar has managed its stock to all-time highs in recent months and hardly wants the investing public to know the unpleasant truth, a truth which is shown in its simplest format in the chart below: Starting in December 2012 and continuing through today, Caterpillar has reported 19 consecutive months of declining global year-over-year retail sales. The last, and only, time it had 19 consecutive months of such decline? The period starting in October 2008 is just when Lehman filed for bankruptcy.”
Chart courtesy of Zero Hedge
Summing up, Durden wrote: “So if we are to call that first period of 19 consecutive months of CAT sales decline the "Great Financial Crisis", we are confused: is the proper name of this identical 19-month period of declines beginning in December 2012 the Great Recovery?”
Again, we ask why don't companies use the $$$'s allocated for share buybacks to instead expand operations, buy capital equipment and/or hire employees? That would help the company grow real sales/earnings and aid the economy, which continues to limp along five plus years into this so called economic recovery. See Victor's comments for more on this phenomenon.
Other Voices on Stock Buybacks:
Andrew Smithers wrote in the Financial Times:
"U.S. companies have been the key buyers of the stock market and the rate at which they have been buying shares is unsustainable, because debt cannot continue to grow at the pace needed to finance the purchases."
He followed that comment in an interview with Kate Welling on Wall Street (subscribers only) published on July 25th:
"This (share buybacks), of course, is destroying value. If you buy assets for paying a lot more than they're worth, you destroy value. But again, here's another place where there can be a big difference in shareholder interests........ If you are a long term shareholder and you're seeing somebody coming in and destroying the value that remains, you very well might (object)."
The granddaddy award comment on share buybacks goes to David Stockman, who wrote in a blog post:
"Since Q1 2008, the S&P 500 companies have distributed $3.8 trillion in stock buybacks and dividends out of just $4 trillion in cumulative net income. That’s right, 95 cents of every dollar they earned—including the huge gains from restructurings, downsizings and job terminations—was flushed right back into the Wall Street casino (share buybacks).
"Needless to say, that is the opposite of the “growth” and “escape velocity” story that currently excites stock market punters, and is wildly inconsistent with present capitalization rates in the stock market. That is, in a world of permanent zero growth and nearly 100% earnings distribution, the S&P 500′s current 19X PE on reported earnings would be wildly too high. The more appropriate P/E would be in high single digits."
"So the $3.8 trillion of dividends and buybacks since Q1 2008 reflects not the natural economics of the market at work, but the artificial regime of monetary central planning and the tax-advantaged treatment of corporate debt. Corporations are eating their seed corn because boards and CEO’s function in a Fed-created financial casino where they are massively incentivized to feed the fast money beast with ever larger share buyback programs in order to shrink the float and goose per share earnings. Doing so generates plump stock option gains, and failure to do so will bring on the black plague of shareholder “activists” agitating for big stock buybacks with borrowed money, and a new CEO and board, too. Moreover, this pattern is owing to the fact that the Greenspan/Bernanke/Yellen “put” under the stock indices has destroyed two-way markets and the natural short interest that arises in any honest securities market."
The purpose of "Capital Markets" is to raise money ("Equity Capital") to facilitate the building or adding to a business venture. This includes brick and mortar projects, hiring employees/contractors, purchasing machinery, or to build new software products and services like Google, Amazon, Facebook, and Twitter have done for the Internet/Web 2.0.
What's so strange about the current "upside down" Capital Markets environment is that instead of "raising capital" to grow a business, corporate America is "depleting and spending capital" -- and (in many cases) borrowing via new debt to buy back shares. It's apparently an attempt to temporarily raise the price of the stock by lowering the float -- shares outstanding - and thereby increasing profits per (fewer) shares. This comes in an environment where there is no real growth, as business sales and revenue are generally flat. So we have "growing earnings/share" with little growth in earning or revenues!
If a company needs to reduce the shares outstanding to increase earnings per share, it seems impossible for it to be valued at 16-20 times earnings on a fundamental basis. So "when" -- not "if" -- a recession occurs and the need for capital is necessary, the company may need to sell equity to obtain that capital. But that will be when they least want to sell -- after the share price has declined in anticipation of lower earnings.
The bottom line here is that corporations are buying (back shares) high now and may be selling low (when they truly need working capital) later. That is not the "Baron Rothschild” method of making money in the market. His method says "The time to buy is when there's blood in the streets." Not after the market has made a serious of new all-time highs which were not supported by real economic growth.
The desire to keep the share price rising is, of course, normal for any corporation's Board of Director's. However, the current administration's fiscal policies (tax and regulate) are not conducive to building a business. Therefore, hoarding and buying back shares is the result for many companies.
The most incredible observation of all this is that after five plus years since the recession officially ended, stated GDP growth is lower than any time since the 1930's depression and recovery (1932 -36).
Certainly, it would be logical to change direction, but the Fed continues to practice its failed monetary policy, which enables the administration to continue its failed fiscal policy. Therefore, the game continues until a meaningful geopolitical event, or a government mistake causes these (high risk) failed policies to come to the surface and weaken both the economy and the financial markets. Unless a dramatic change (or shock) occurs, expect more of the same. But when the music stops, don't expect everyone to find a chair.
Till next time........................
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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