DOCUMENT 15 OF 26
DOCUMENT 15 OF 26
BW9805000102
Finance: CORPORATE FINANCE
SHARE BUYBACKS THAT PAY BACK IN SPADES
Hedging techniques are earning millions in tax-free income for savvy
companies
By Jeffrey M. Laderman in New York
1606 Words
9838 Characters
02/23/98
Business Week
98
(Copyright 1998 McGraw-Hill, Inc.)
Thousands of companies have gone into the stock market in recent years to
buy back billions of their own shares. But perhaps only 100 or so have turned
to savvy hedging techniques that help execute those buybacks--and earn
tax-free millions to boot. Dell Computer Corp. has saved itself about $1.6
billion in the last two years. Microsoft Corp. reaped $600 million in the past
three-and-a-half years. Smaller fry are playing too: Appliance-maker Maytag
Corp. netted $10 million over the past year.
Just how often these techniques are used is hard to say. Most companies
don't trumpet the deals. In some cases, evidence of the transaction shows up
as an entry on the balance sheet and in the company's financial statements.
Among the companies that have used these techniques are Boeing, IBM, Intel,
and McDonald's.
PRIVATE CONTRACTS. But perhaps even more often, these buyback-related
transactions never see daylight: They are private contracts between companies
and their investment bankers, and the rules require that companies disclose
them only if they are ``material''--and that's a judgment call the company
makes itself.
By all accounts, this sort of dealmaking will be on the increase as
companies continue to repurchase shares even at today's high prices. Under new
accounting rules, companies must also report their income as though the stock
options they have granted over the years had been exercised. That means
diluting today's income over more and more shares. The only way to offset that
is to reduce the number of shares outstanding. Companies can reduce their
shares just by buying in the market.
But there is often a better way. Microsoft's millions come from selling
``put warrants'' in conjunction with its share repurchase program. In such a
transaction, the seller gives the buyer, usually an investment bank, the right
to sell shares of the company stock to the company at a predetermined price,
called the strike price. This right has a finite life, say, 12 months.
For this right, the buyer pays the seller a fee or premium. For instance,
* for a stock selling at 40, a one-year put warrant with a strike price of 40
might sell for about $3 per share for 1 million shares (table). That $3
million is free and clear to the issuer since the tax code allows corporations
to sell options on their stock tax-free. ``It's one of the few sources of cash
that isn't ultimately taxable,'' says Robert Willens, tax and accounting
analyst for Lehman Brothers Inc. ``That's what makes put warrants so
attractive.''
If the stock takes off and the price at expiration is above the strike, the
put will expire worthless, and the premium is pure profit. True, it will cost
the company more to buy the stock in a rising market, but the company can use
that premium to offset the somewhat higher cost. ``This is not a substitute
for a share buyback program,'' says Christopher Innes, a managing director at
NationsBanc Montgomery Securities Inc. ``But if a company has already decided
to buy back its stock, why not get paid for that decision?''
Indeed, Microsoft has been paid in spades. The company has sold 30 million
to 40 million puts a year, and not one share has been ``put'' back to the
company. Microsoft sells puts on a continuous basis, timing the sales to each
year's buyback plan and staggering the expirations. All together, Microsoft
now has about 23 million put warrants outstanding. ``This strategy makes all
the sense in the world for successful technology companies,'' says Gregory B.
Maffei, Microsoft's chief financial officer. ``They're cash rich and face tons
of employee stock options.''
What if the company is wrong about its stock's prospects, and the shares
head south? Should shares trade below 40 at expiration, the warrant is ``in
* the money,'' and the investment house will put the warrant back to the
company--that is, force it to buy shares at 40. So if the shares are at 38,
the company pays $2 a share over the market price, a loss offset by the $3 a
share it earned on the premium. Of course, if the price is below 37, the
company's position is a net loss.
LOST OPPORTUNITY. ``You win if the stock goes up, and you win if the stock
goes down a little,'' says Eric B. Lindenberg, a managing director at Salomon
Smith Barney. ``But if the stock goes down a lot, you forgo the opportunity to
buy at a much lower price.'' In selling puts, the company is committing itself
to buy the stock at the strike price when the put expires.
If the deal is so sweet for the company, what's in it for the likes of
Salomon and NationsBanc? In buying the warrants, the bankers have to lay out
cash for the premium. The investment house doesn't want to be caught with a
worthless warrant either, so they hedge the warrant by buying the company's
shares in the open market. But they don't have to buy one for each warrant.
Using a sophisticated hedging model, they figure they can hedge, say, 1
million warrants with 400,000 shares.
So how does the investment bank make money? If the stock goes up, the
warrants look more and more like losers. But as the stock rises, the put owner
needs fewer shares to hedge the position. So the investment firm sells some
stock into the open market and realizes some profits. If the stock winds up
below the strike, the investment bank collects $40 per share no matter how far
the price falls.
Some companies take the put-buyback technique a step further. Dell Computer
considered selling puts when it launched a buyback program two years ago. But
Dell executives wanted to lock in a price for the shares they needed to buy
rather than relying just on put premiums to offset some of the cost.
So Dell set up a ``collar.'' It sold puts, then took the premium and bought
calls. The calls gave Dell the right to purchase a set amount of shares at a
fixed price. So, as Dell's stock soared past the calls' strike prices--it's up
more than 1000% since the buyback program began in February, 1996--the company
locked in shares on the cheap. What's more, the calls allowed it to buy shares
it might not otherwise have been able to afford. Though the company is flush
with cash now, it wasn't when the buyback began, says Dell Treasurer Alex C.
Smith.
In all, Smith says the company repurchased 68 million shares at a
split-adjusted price of 20. The average price of the stock during that time
was 43, according to Bloomberg Financial Markets. BUSINESS WEEK estimates
Dell's savings at about $1.6 billion.
STAR PERFORMERS. Of course, the reason the buyback programs at Microsoft and
Dell fared so well was that the stocks were star performers. That's not always
the case. A few years ago, biotech giant Amgen Corp. tried the collar approach
as well--but its stock went nowhere, and both the puts and calls expired
worthless. Then, with the stock around 50, Amgen Treasurer Larry May says the
company sold puts at strike prices in the high 40s. ``We believe our stock is
cheap and would not mind buying it at those levels.'' Amgen is now at 54.
Until now, the big investment banks have dominated the put end of the
business, customizing options to each client's needs. Now, the Chicago Board
Options Exchange, the largest options exchange, is making a push for the
business as well. William Barclay, CBOE vice-president, says the exchange will
soon get the regulatory clearance to offer more competitive options with more
flexible terms. Until then, it's the big boys' game.
There's no question the put-buyback technique and its variations work best
when a company's stock is on the rise. With the bull kicking up the dust
again, more and more companies will be looking for ways to save money on their
buyback plans. And the list of savvy companies is sure to get longer.
A Primer on Buyback Puts
Company X's board authorizes the repurchase of up to 2 million shares of
stock, selling at $40 per share, over the next year. The company sells puts
on, say, 1 million shares with a strike price of 40 to an investment bank. The
company
collects a premium of $3 per share, or $3 million in all. The investment bank
wants to hedge its put position, so it buys stock in the open market. Using a
sophisticated model, the bank determines it needs to buy 400,000 shares.
COMPANY X
As long as the stock remains above 40, the puts will expire worthless, and
the company will keep the premium, tax-free. The company can use that money
to offset the higher cost of buying shares.
If the stock is below 40 at expiration, the put will be exercised and the
company will have to buy the shares at 40. But some of that higher cost is
offset by the income from selling the puts. If the stock is below 37 at
expiration, the company loses money.
INVESTMENT BANK
As the stock rises, the bank sells some shares to offset the likely losses
on the puts. If the stock is at 50 when the put expires, the puts are
worthless but the bank has been making money selling the stock at higher and
higher prices.
If the stock declines, the bank buys more stock to hedge the position. But
if the put is below 40 when the put expires, the investment bank will ``put''
the stock back to the company at 40.
DATA: NATIONSBANC MONTGOMERY SECURITIES INC., BUSINESS WEEK
Photograph: Photograph: ``This . . . makes all the sense in the world
for [tech] companies. They're cash rich and face tons of employee stock
options''
--GREGORY MAFFEI, Microsoft
PHOTOGRAPH BY REX RYSTEDT
I0607 * End of document.
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