Over the past decade we have been concerned about the shift in management focus from growing revenues to financial engineering. The use of “adjusted” earnings instead of GAAP (generally accepted accounting principle) earnings has been deeply concerning and regularly exploited. As the compensation packages of executives have become increasingly tied to the performance of non-GAAP metrics and the proportion of their compensation awarded via stock options has skyrocketed, there is a tremendous amount of incentive for executives to juice their earnings. For further information on non-GAAP earnings please refer to our previous blog here.
In this article we will focus on a more traditional form of earnings manipulation, one that has seen a significant increase in popularity recently: share buybacks. Historically, when it was prudent to do so, management would decide to utilize their excess cash to repurchase a portion of their shares instead of paying dividends or reinvesting in their business.
There are two reasons a company should spend their cash to repurchase their shares. First, if the company believes that the price of their shares are selling for a significant discount to what they believe they are worth. Management, having access to inside information about the status of their business, should have the most accurate picture of what their company is worth. The second reason is if a company no longer feels they can reinvest their cash back into their business and earn an adequate return for their shareholders. This typically plays out for mature companies that no longer have attractive growth opportunities ahead of them. If a company is repurchasing their own shares for any reason aside from those mentioned above, investors should seriously question the validity of whether this is the best use of shareholder cash.
A key metric that investors use in investing is the earnings per share (EPS) of a company. Specifically, investors will look to see if the EPS of the company are growing. However, it is important to distinguish whether the EPS of a company is increasing because revenues are growing, whether earnings are growing because margins are expanding, or because the company is levering itself up by adding debt and buying back shares. The problem with the two last sources of earnings growth is that they are inherently self limiting as margins and leverage can only go so high and thus tend to be short term in nature. P/E ratios are a discounting mechanism and factor in long term growth in earnings. Short term increases in earnings can provide a higher base of earnings for the denominator of the P/E ratio but should not be reflected in higher P/E’s themselves when the growth is not sustainable. The ONLY source of long term earnings growth that should be reflected in ever higher market multiples is higher sustainable revenue growth.
How does higher financial leverage result in higher earnings? Earnings are growing simply because the company has reduced its share count by buying back shares with debt or cash. We can illustrate this with a simple example by looking at a two year period:
Assume Company XYZ has 100 shares outstanding and that each share is currently priced at $100. Last year, Company XYZ earned $1,000 or $10 per share for each of the 100 shares outstanding. Next year because sales are flat the company is expecting to earn another $10 per share or $1,000 total. Because the earnings per share are not growing the company is trading at a low P/E ratio of 10 times or $100 per share in the market. Note that this company failed to grow their earnings year over year. Recognizing that this will likely have negative ramifications for their share price, the management of Company XYZ decides to borrow $5,000 in cash at a 5% interest rate to buyback 50 shares ($5,000 in cash ÷ $100 price per share equals 50 shares) in year two. Note the earnings yield on the stock (inverse of the P/E ratio) is $10/$100 or 10 percent and the cost of the debt substituted for shares is 5% as the lender is willing to accept a 5% yield versus the shareholder who is demanding a 10% yield. As a result, the shares outstanding decreases from 100 to 50 shares in year two. As a result, the EPS of the company increases from $10 in year one to $15 per share in earnings in year two ($1,000 in earnings less $250 in interest expense on the new debt or $750 ÷ by 50 remaining shares after the buyback) for a perceived increase of 50% in earnings per share. Even though the company’s sales and income were flat year over year this financial engineering has created the impression of 50% earnings growth on a per share basis. The market then rewards the company with an increasing P/E ratio from 10x to 15x because of the perception of growth. The market hence rewards the shareholders by increasing the share price by the increase in the denominator (i.e. the E in the P/E ratio) by 50% and again by the increase in the P/E ratio itself by 50% for a total gain of 125% to $225 a share.
Now one could argue the increase in earnings should be rewarded because effectively the remaining shareholders found someone (i.e. the debt issuer) to accept a 5% return, instead of the 10% demanded by their former shareholders, so that half the 10% return afforded the previous shareholders now accrues to their benefit. However where the scam is occurring is in the stock market, where the P/E ratio has now gone to 15x from 10x due to this unsustainable perception that earnings are growing quickly, when in fact revenues and corporate income are stagnant. Management will continue this practice as long as the balance sheet permits it and the debt buyers are willing to subsidize the shareholders by accepting a subpar return for the risk they are assuming. When the balance sheet is ultimately destroyed if this persists, the bondholders will realize there is no difference in their risk positions relative to the shareholders, as there is no longer a “first in line” on insolvency.
Generally, buying back shares is a good complement to organic growth for total shareholder return. When it becomes a concern is when this technique is used to create the illusion that the company is growing when it is not, and therefore debt is regularly relied upon to buy back shares instead of merely using excess cash flow to do so. In recent years, given the ability to create the illusion of earnings growth by reducing the share count with cheap interest rates, management teams have taken advantage of this and loaded up on debt in order to do so. If management is being compensated by earnings per share growth this becomes a very enticing practice. In an unsophisticated market, this has also led to higher multiples being applied to these inflated earnings.
One real life example that clearly illustrates this is Apple. Summerhill held this stock for many years, when under the watchful eye of Steve Jobs. At the time, Apple was truly a stellar grower and its shares traded at a reasonable price, in what was then a relatively benign stock market overall.
However, over the past five years in particular, despite all the hype by commentators and analysts alike, a simple look at the numbers would indicate that Apple is not the growth story of the past:
It is clear from the chart above that revenue growth in more recent years has barely been higher than the growth of the overall economy on average and net income also has been flat for the last five years. But what you will notice is that over this same time period, the company has loaded up on short and long-term debt and used the proceeds to aggressively buy back their shares in order to boost their earnings per share to make it look like the company is growing faster than it actually is. Recall from our prior example, that a reduction in the shares outstanding will increase the earnings per share number even if the actual earnings are not growing if the cost of the buyback (interest expense in the case of debt or foregone interest income in the case of balance sheet cash) is lower than the earning yield of the shares.
Generally, a discerning investor does not pay a premium multiple, (that is a multiple in excess of the market multiple), for a stock with little to no organic growth. Yet the price of Apple’s stock would indicate otherwise as it has gone up spectacularly over the last three years. The multiple on Apple shares has gone from 12x earnings per share in 2013 to 28x today as this illusion of growth has been robustly rewarded by the market.
This probably won’t end well for several reasons. As the P/E multiple climbs the earnings yield (remember this in the inverse of the P/E ratio) falls, and as the balance sheet absorbs more and more debt, lenders get nervous and demand higher and higher interest rates to compensate them for the risk.
At some point given the convergence between the earnings yield and the cost of debt additional leverage will fail to produce additional earnings growth per share or substantially less. The amount of new debt to get the same earnings per share growth has to keep climbing higher. Ultimately it is unsustainable. When the apparent growth in earnings per share finally converges toward the growth in revenues, the party is finally over and the P/E now goes into reverse, falling aggressively to match the decelerating growth in earnings per share. Eventually management runs out of bullets leaving the shareholders holding the bag. For Apple it is not a question of “if” but of “when”. Buyer beware.
Apple P/E Ratio and stock price: 2013-Present
It is not clear to us, why anybody would want to pay over 15x earnings for this type of “growth.” It is also hard to understand why analysts are not distinguishing between real organic growth and growth by balance sheet expansion given the latter can only go so far.
Under the leadership of Steve Jobs, the innovation at Apple was exponential. The company disrupted markets by launching truly ground breaking products. With each new product launch the company added a new revenue stream and expanded its total addressable market for which it could monetize. The stock price moved in lock step with each new innovation and the revenue potential it unleashed. Today, the innovation at Apple tends to be less stellar and more in the form of offering different colours of the iPhone or adding to the emoji library. Its announcement this month of software enhancements are great for Apple users, but were mostly already in Android (Google) phones since 2014.
The excitement and growth around the Apple story has faded. Perhaps we will be surprised again and that the future for Apple is bright. Maybe they will be the leaders in augmented or virtual reality. Maybe they will bring forth some exciting new product that will provide another decade of better earnings growth. But for the moment, given the recent track record, it is hard to justify its current multiple. Ultimately the company sells a consumer product which is more and more commoditized as time goes on. There is nothing it can offer that is now not found in competing phones with android operating systems. In fact some argue that the pixel might just be a better phone. It certainly has a much better camera. Either way, the iPhone is a consumer product which is not growing faster than the market and for this reason there is little evidence why the stock should be priced with any premium to the market at all.
The Summerhill Team