Are share repurchases effective signals to the market? How does repurchasing banking firms' long-term operating performance compare to an industry average?

Publication: Bank Accounting & Finance

Publication Date: 01-JUN-06

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COPYRIGHT 2006 Institutional Investor, Inc.

Agency theory proposes that the decisions of the managers (agents) should lead to value maximization for their shareholders (principals). When faced with excess cash, managers have to choose among the various alternatives for use of the funds: investments, operations and cash payout (dividends and repurchases). The REL Consultancy group looked at the data for 1,000 U.S. companies in 2003 and found that their excess cash constituted 15 percent of the total capital and 11.5 percent of total sales, up from 11 percent and 8.5 percent, respectively, in 2001. (1) Similarly, the Financial Analysis Lab at Georgia Tech reviewed the data from 86 nonfinancial firms in the Standard & Poor's (S&P) 100 index and found that free cash flow (operating cash flow exclusive of onetime and nonoperating items) grew from $231 billion in 2002 to $259 billion in 2003. (2) Firms have been increasingly distributing the excess cash in the form of share repurchases, as evidenced by looking at the aggregate data from Compustat during 1980 to 2000, when repurchase expenditures as a fraction of earnings increased from 4.8 percent to 41.8 percent, and the average annual rate of growth of share repurchases compared to the dividend growth rate of only 6.8 percent. (3) The trend is accelerating, as shown by companies in the S&P 500 stock index spending $197.5 billion in 2004 and $163.0 billion in the first half of 2005 on share repurchases, up from $131 billion in 2003. (4)

Share repurchases reflect corporate strategies that are closely related to the firm's investment, financing and operating decisions. Previous empirical studies have addressed the rationale and impacts of share repurchases in the nonfinancial sector and have presented a mixed picture on the motivation behind share repurchases and the reasons for the market reaction to the repurchase announcement. (5) The studies put forth these corporate finance theories as the reasons for engaging in share repurchases:

* Signaling (management trying to communicate to the market that the shares are undervalued relative to inherent earnings ability)

* Time inconsistency (firm's record of satisfying prior repurchase commitments before announcing new programs)

* Cash flow (distributing the excess cash flow to shareholders instead of managers deploying it to value-diminishing investments)

The studies showed strong support for the cash flow hypothesis and weak positive support for the signaling hypothesis. Exhibit 1 shows the conceptual framework of existing share repurchase hypotheses.

[EXHIBIT 1 OMITTED]

Banking firms typically try to use a combination of share repurchases, dividends and investments (acquisitions) to disperse excess capital from strong balance-sheet growth during any given year, but many financial institutions are already at the high end of dividend yields and have limited acquisition possibilities. During 2004, the dividend yield (dividend divided by share price) for banks was 3.12 percent, compared to the average dividend yield for 379 companies in the S&P 500 index of 1.92 percent. The dividend payout for the top 50 banks ranged from 40.0 percent to 50.0 percent of operating earnings. (6) Prior studies found that during 1988 to 1997, average repurchases by bank holding companies increased from $1 million to $14 million, with repurchases as a share of earnings increasing from three percent to 50.0 percent. (7) These studies examined the role of repurchases in the financial services sector, but their results have been inconclusive about the reasons for, and the effect of, repurchases. The increased prominence of repurchase programs reflects their importance in the implementation of the banking firms' corporate strategies, mirroring the trend in the nonfinancial sector.

Some comments by bank analysts are quite revealing about the motivations behind share repurchase:

* Dennis Laplante of Keefe, Bruyette and Woods: "Once you establish a dividend payout, you cannot reduce it.... Share repurchases can be made anytime. They also have the effect of improving financial ratios, including earnings per share and return on equity." (8)

* Gerald S. Cassidy of RBC Capital Markets: "[Repurchase] is one of the rabbits bankers take out of their hats, though it is a legitimate one when revenue growth falls short of expectations."

* Nancy Bush of NAB Research LLC: "[U.S. Bancorp.] management is targeting a 50% payout ratio.... Returning capital to shareholders also signals that U.S. Bank will not do a big dumb bank deal." (9)

* Jeff Harte of Sandler O'Neill and Partners: "[Citicorp] has got a ton of capital coming in. Only thing they can do with it is to buy back stock." (10)

* Brad Hintz of Sanford C. Bernstein & Co. LLC: "If Schwab had done a buyback last year it would have had a pro forma effect of increasing return on equity from 11.1% to 12.5%, and earnings per share by 2.3%." (11)

This study concentrates exclusively on open market...

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