By Gregory M. Drahuschak

Sunday, July 30, 2006

U.S. companies have been buying back their own stock at a blistering pace. According to Standard & Poor’s, during the first quarter of 2006, companies in the S&P 500 spent roughly $100 billion of their idle cash repurchasing shares, a 22 percent increase above the same period in 2005.

Even more notable is that S&P 500 companies spent 45 percent of their capital expenditures on stock buybacks last year. Largely, shareholders initially have a favorable reaction to this redeployment of cash, but it might not be the road to increased shareholder value that theory suggests it can be.

Cash on the balance sheets of U.S. companies is at record levels. The pressure to do something with it probably is as great as it ever has been. As good as large cash balances might seem to be, at times, they can be warning signs shareholders should heed.

The theoretical benefit of retiring shares by buying them back from public holders is simple. Shrinking the number of outstanding shares divides the same level of corporate earnings into fewer but larger pieces, which should be more valuable assuming nothing else in the company changes. The actual performance of stocks that have implemented major stock buybacks, however, is mixed.

Proponents of stock repurchases argue that the buying stabilizes the price by putting a floor under the stock. Here, too, theory and reality do not always match. The floor notion assumes that companies use a fixed price range to execute their buying. Also, unless it continues forever, at some point the notion of a floor no longer applies.

Stock buybacks in some cases also end up providing companies with shares to fund stock option grants, which means that ultimately the hoped-for share count reduction never really happens and company control reverts increasingly to the company’s management.

Record corporate profits have increased shareholders’ demands for more direct participation in those profits. Counting on the open market to provide a boost in the stock price to account for the cash often does not happen. Too much cash often is viewed as a wasted asset since the return on cash typically is much less than the return on assets many companies achieve in their base businesses.

The impreciseness regarding how buybacks affect stock prices has given rise to a demand for more concrete use of excess cash. Typically, three other moves might accomplish what shareholders want.

Companies with excess cash can make acquisitions to enhance their overall corporate results. Major capital expenditures to improve existing operations are viable alternatives, too. As long as either move comfortably beats the return on cash, the expenditure is a good redeployment of the money.

The purest form of directly compensating shareholders, however, is accomplished by sending it directly to shareholders as dividends; a move that considering the currently reduced dividend tax rate, has become an increasingly popular option in shareholders’ eyes. Many times, however, managements do not see it the same way.

If a company truly believes that attractive acquisitions will become available, sitting on the cash for a time makes sense. The key is how long it continues. In a few major companies, cash has been at monumental levels for years.

As comfortable as you might feel with a company that has tons of cash on hand, it could be a major red flag. The company might be signaling that it is out of ways to utilize the cash that make good business sense. In this case, rapidly increasing the dividend could be the best action to take.

Cash can be king at times, but too much of it could be a better indication that the firm’s best growth days have passed.

It’s amazing in an era of increased shareholder activism that cash collecting relative dust on balance sheets is as great as it is.

If you own a cash rich company, make sure management is using the riches wisely.

Buybacks are not always the wisest use.