US airlines show it is time to switch off buyback machine
As the tide recedes on stock markets with the spread of the coronavirus pandemic, it has not taken long to reach the “Warren Buffett moment”. That is when we discover who in the ebbing market “is wearing shorts and who was swimming naked”, as the billionaire investor once said.
Conspicuous among those lacking apparel in the present turmoil is the US airline industry. Having lavished a thumping 115 per cent of their free cash flow on share buybacks since 2014 (and that is aside from their regular dividends) America’s four biggest airlines have precious little to cover their pecuniary embarrassment. They lack the financial flexibility even to contribute materially towards the costly business interruptions that loom.
Not being some optional extra but a crucial part of the US economy, that fragility has been dumped wholesale in the laps of the hard-pressed American public. Taxpayers are being asked for a $50bn bailout just to keep the airlines in the skies.
Of course, airlines are not the only industry to have hollowed out their balance sheets with share buybacks, making themselves less resilient to downturns. In 2018, impelled by the boost to corporate profits delivered by President Donald Trump’s tax cuts, companies in the S&P 500 index repurchased $806bn worth of their own shares, beating the previous 2007 record by $200bn. Last year, they gobbled up $730bn.
Nor have they confined themselves to surplus cash flow to do it. The proportion of buybacks funded by corporate bonds was as much as a third in 2016 and 2017, according to research by JPMorgan Chase.
Now there is nothing wrong in principle with returning capital to investors. Companies in mature industries might lack sufficient appealing investment opportunities to absorb their surplus cash. But the buyback movement has been driven by less innocent motives. Leveraging simply to buy back shares is, as a recent article by three academics observed, “bad management, given that no revenue-generating investments are made that can allow the company to pay off the debt”.
Its real appeal to bosses lies in the scope for financial engineering. After all, buybacks do not simply gear a company’s balance sheet; they also supply a further twist by reducing the number of shares in issue. The result is to manipulate upwards the earnings per share number — sometimes dramatically.
The main beneficiaries are not shareholders; buybacks tend to happen when share prices are rising anyway, and they run the risk of companies destroying value by purchasing overvalued equity. The biggest winners are managers whose pay is tied to stock market measures such as EPS growth.
In many sectors, this has been all but formalised into a mechanism for self-enrichment, according to the investor Ben Hunt. Take Microsoft for instance, whose managers have perfected the art of plucking the shareholder goose without much hissing.
In 2018, the tech company bought back 150m shares, “returning” $16.8bn to investors. Yet in the same year, Microsoft issued 116m new shares to employees as they exercised options or vested previously restricted stock units, in return for which it received a paltry $1.1bn in subscription cash. The net effect of this buying-high-and-selling-low strategy was to transfer 70 per cent of the value of the buyback into managers’ pockets.
That is not the only way that buybacks can hurt investors. There is also the problem that managers become focused mainly on running a sort of hedge fund with a commercial business attached.
Just look at Boeing under its buyback-loving former boss Dennis Muilenburg. The aircraft maker’s repurchase of $43bn of its shares between 2013 and 2019 made Mr Muilenburg extremely wealthy, helping him in 2018 to pocket $30m in compensation and gains from exercising options. But it was financed by squeezing the development cost and cutting corners on the 737 Max, whose fatal flaws and subsequent grounding have thrown the company’s future into doubt.
There is nothing now to be done about the extraordinary gains made by the Big Four US airline chief executives since 2014, when they gobbled $430m in stock-based compensation. American Airlines chief Doug Parker banked $150m from selling the carrier’s stock over that period. Ed Bastian of Delta has raked in another $127m, despite only becoming CEO in 2016. That money is not coming back.
But investors should get wise to the conflicts that drive the wealth-transferring buyback engine. In the case of the airlines, that should mean leaving them to bear the financial hit for their inattention. That includes Mr Buffett, who, with Primecap Management, a large US fund, owns a quarter of the Big Four carriers’ equity.
Stock market investors talk a lot about sustainable investment. Maybe it is time they thought harder about the financial sustainability of the businesses they own.