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Past share buybacks haunt some US companies

Standard & Poor’s 500 companies have spent $1.73 trillion on buybacks up to September since the fourth quarter of 2004, according to the ratings company. With the U.S. in a recession, the companies face the threat of additional credit-rating downgrades after being punished for the earlier borrowing.

But what was the trick behind, which pushed serious companies such as Macy’s or Gannet to buy back their shares? And (hard to believe), even by borrowing money to do so?

The logic is quite simple – if your shares are traded at a big discount, buying them back effectively diminishes the number of shares traded. It means that the same market capitalisation (since no value is added or created through the process) it is spread over a lower number of shares. This, in theory, should boost the market value of the remaining (traded) shares and thus create value for the remaining shareholders.

But why borrowing to buy back your shares? Well, although we at think this is a little bit exagerated, there might be a reason behind for this too. If the borrowing costs are very low (as it is the case in the US right now, where the companies can get loans for 3-5% a year), then it becomes attractive to borrow those money and use them for something more profitable. Like buying back your undervalued shares. The trick here is to see a gap in your trading price much larger than the borrowing costs. Which, with the help of the current recession, where Dow Jones is more than 20% lower than 3-4 months ago, is not hard to believe.

But the market is currently punishing some companies who have pursued this strategy too aggressively recently. New York Times, with $1.1 billion in total debt, spent more than $1.8 billion buying shares from 2000 to 2004, enough to have retired all of its borrowings, said Mike Simonton, an analyst at Fitch Ratings in Chicago. Gannett could have paid down most of its long-term debt with the $3.44 billion spent on buybacks since 2004. Macy’s recently renegotiated its bank loans to erase doubts that it could repay loans due next year.

S&P cut the New York Times’ debt rating three levels to a BB- junk grade in October and has a negative outlook on the company, signaling further reductions are possible. A $400 million credit line is due in May.

Gannett, the largest U.S. newspaper publisher, had to draw on unsecured revolving credit in October to repay commercial paper. The McLean, Virginia-based publisher’s debt rating has slid six levels since 2000 to BBB-, one step above junk.

Gannett, with $3.91 billion in long-term debt of Sept. 28, didn’t buy back shares in the third quarter in favor of reducing debt and using cash for acquisitions.

The company, which also operates TV stations, offered to purchase $750 million of notes maturing in May for 95 cents on the dollar. Holders of 13.5 percent of the notes accepted the offer.

Home Depot, the world largest home-improvement retailer, followed the same trend with plans in June 2007 to buy back $22,5 billion of its shares, financed by the sale of its HD Supply unit and $12 billion of bonds. Being perceived as a poor financial engineering, Home Depot subsequently faced cuts in all of its debt ratings – Moody’s was cutting its debt with 3 levels down to BBB+.

Macy’s, the second largest US department store, also bought back $3,32 billion in 2007, which also led to a rating from S&P of BBB-. All of a sudden, all these trillions spent on buybacks look like foolish acts of financial engineering. only if we think that in the first half of 2009 there are 73,000 stores projected to be closed and if we look at the poor industry sales, and it’s enough to show the dimensions of this mis-directed spending.

The buyback trend shows, from our perspective, that not only the banks, but also some companies were lured in the financial complexity game. Many companies thought they can be more profitable buy buying back their shares rather than investing heavily in their own businesses. In the current recessionary environment, this of course can be a very costly mistake, and some of the huge company failures lurking ahead will have this as a cause…

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