Bank Shareholders, Beware of Stock Repurchases
Stock repurchases have increased in popularity among banks. Large institutions like Chase and Citi and smaller banks like First Horizon have or are considering open market repurchase programs.
In fact, bank repurchase activity is up over 50% from 2010. It is at its highest level since 2007. An additional boost of credibility was provided by Warren Buffet’s recently announced first ever repurchase program.
The increase reflects the inability of banks to reinvest profitability the excess capital generated from returning profitability and contracting balance sheets. Organic growth continues to be hampered by the weak economy. Mergers and acquisitions remain depressed due to regulatory and purchase accounting complications.
Activist shareholders are another concern for banks facing limited reinvestment opportunities. Major investors are seeking the return of excess capital rather than retain it within the bank where it might be reinvested in low return projects. The pressure on management to return excess capital is expected to grow. The decision to return capital raises the question of how to return capital.
Share repurchases, aside from possible technical tax differences depending on the tax status of the banks investor clientele, have similarities with dividends as a cash distribution mechanism. For example, a special dividend combined with a reverse stock split yields the same result as a share repurchase. Dividends and repurchases differ, however, in certain important respects. For example, earnings per share will be higher with a repurchase compared to a dividend. This is true even though return on equity is the same for both distributions. Thus, repurchases can be used to disguise poor growth through manufactured earnings per share expansion.
Another difference concerns the allocation of value between the selling and remaining shareholders. That is because all shareholders are paid with dividends. Only the selling shareholders are paid in a share repurchase. Remaining shareholders are penalized when shares are purchased at a price above their intrinsic value. In that case, value is transferred to the selling shareholders from the remaining shareholders. Managing this risk is difficult as it can only be assessed after the fact. Historically, banks are poor at timing share repurchases at appropriate prices.
A simple discount to book value is insufficient to justify a repurchase. The discount may be warranted due to poor earnings prospects or asset quality concerns. Management over-optimism frequently results in over-paying departing shareholders at the expense of those who stay. Particular attention is needed to guard against repurchases that are overpriced to influence stock prices by increasing earnings per share. Managers seeking to game incentive compensation systems tied to those measures will propose repurchases. Earnings per share improvements following a repurchase are, however, offset by a falling price to earnings ratio without necessarily increasing the bank’s long-term value. Repurchases affect the distribution of value, not the creation of value as operating results remain unchanged.
Boards reviewing a repurchase proposal should follow a three-step process. First, they need to understand and approve the motive for the repurchase. Motives other than the efficient return of excess capital should be challenged. Next, directors must understand the conservatively calculated intrinsic value of the bank. They should approve stock repurchases at prices only below that value. Thus, managers should be required to justify repurchases prices based on credible intrinsic value estimates.
Boards should be skeptical of managerial undervaluation claims as the stock price may reflect poor investor communications. This should correct over time. More seriously, investors may not believe in the value of management’s strategy. When in doubt, a special dividend may be preferable over a potentially overpriced repurchase.
Finally, as with dividends, the regulatory impact of the repurchase must be assessed. Only highly rated institutions with excess tangible equity and low classified asset ratios should consider special distributions. The distribution should be part of an overall capital plan that is tested under adverse macro economic scenarios. Currently, obtaining Federal Reserve approval for buybacks is difficult for larger institutions.
The repurchase decision involves complex valuation and governance considerations. Investors are not and should not be indifferent to those factors. This requires clear thinking by the board to protect the interests of nonselling shareholders against the potentially conflicting motivations of management. Currently, stock repurchases are becoming the financial engineering choice de jour. Unfortunately, their impact is not always positive.
Capital management assumes heighted importance in the current low growth environment. This includes selecting the best means to return capital to shareholders regardless of whether it is fashionable. Repurchases are not necessarily bad, but when misused they can reduce shareholder value. So shareholders beware.
Joseph V. Rizzi is a senior strategist at CapGen Financial Group, a private-equity firm. He spent 24 years at ABN Amro Group and LaSalle Bank.