Thursday, March 7, 2019

Can Share Buybacks Benefit Major Shareholders Disproportionately?

Last month, we had Wal-Mart (WMT) announcing its quarterly results. The results were fine, and it does seem like the company is becoming a formidable competitor to Amazon.

Unfortunately Wal-Mart has been unable to grow earnings per share over the past five years. As a result, the company has kept raising dividends at a very slow pace. Given the low yield, the high P/E ratio, I do not believe that Wal-Mart is a good value today. I expect a slow dividend growth from the likes of AT&T and Verizon, which at least have an above average yield. I do not expect a slow rate of dividend growth from a low yielder with a high P/E ratio like Wal-Mart.

While management does not control the dividend yield, they do control where the money gets allocated. Management is investing heavily in the ecommerce, and integrating the online and offline shopping experience into a seemingly integrated experience. It is quite possible that Wal-Mart a decade from now will earn more money, and be more valuable.

As part of their capital allocation decisions however, management has continued with buying back shares. In general, companies buy shares when they have too much extra cash on hand, but do not want to commit to paying a higher dividend. Shareholders typically expect that dividend payments are kept and gradually increased. If a dividend is increased, and then cut, it makes the company’s situation seem dire. It also makes management look like they are doing a poor job.

If management wants to distribute those excess profits to shareholders, but wants to keep flexibility in the distribution, they can either do a share buyback or a special dividend. Corporations these days tend to prefer share buybacks. Most commentary in the media seems very biased in favor of buybacks, and somewhat opposed to dividends. As a result, the common message sold to ordinary shareholders is that dividends and share buybacks are the same thing, when in reality they offer vastly different outcomes.

The problems with buybacks are that:

1) Management teams seldom do any analysis on whether they are getting a good value for their money when buying back stock

2) Management teams can announce a buyback, but never execute it

3) Buybacks may mask the dilutive effects of stock options on shares outstanding ( executive compensation in stock)

4) More often than not, companies have excess cashflows when their shares are overvalued, hence they tend to destroy value. Companies tend to halt buybacks when we have economic uncertainty, but share prices are low.

5) A dividend treats all shareholders fairly, while share buybacks do not treat all shareholders fairly

After reviewing Wal-Mart’s proxy statements, against the trend in shares outstanding, I came up with another problem with buybacks.

I found that the Walton family, either directly or through trusts, owns more than 50% of the company stock. Just a few short years ago, their ownership percentage was lower.

As a result of share buybacks, Wal-Mart is essentially using your shareholder money to increase the percentage ownerships of the Walton family.

The risk that I am seeing is that management runs Wal-Mart for the benefit of the Waltons. Buybacks have disproportionately helped the Walton family increase its ownerships from 40% to 50%. This is a risk that many investors rarely think about in general, when thinking about buybacks versus dividends.

Back in 2007, the Walton clan owned roughly 41% of shares outstanding:

Source: Wal-Mart's 2007 proxy statement

Fast forward to 2018, when the Walton family owns a little over 50% of the outstanding shares:

Source: Wal-Mart's 2018 proxy statement

However, once the family has asserted control over Wal-Mart, they have followed management in selling their shares. However, they have kept their ownership firmly above 50%. If the family chose to stop selling shares, and management kept repurchasing shares, it is very likely that they will ultimately end up spending shareholder resources to take the company private for the Waltons. In other words, the money that could have been used to benefit all shareholders through a dividend, ended up being used for share buybacks that help the Waltons increase their ownership of Wal-Mart, at the expense of ordinary shareholders.

Some may say that the buyback also increases the value for remaining shareholders. This is great in theory, but in reality this doesn’t really matter much for smaller shareholders like you and me. If I hold 200 shares of Wal-Mart, and the company repurchases 50% of its shares outstanding, my ownership in the company increases. But I am still a minority holder, despite the fact that shares outstanding decreased from 3 billion to 1.50 billion. (or from 6 billion to 3 billion, as has been the case over the past 20 years)

However, if I held 1.5 billion shares initially, and the company reduced the number of shares outstanding from 6 billion to 3 billion, my ownership stake rises from 25% to 50%. In other words, I end up being in control of the corporation, without spending a dime. When you are in control of a corporation, you can do a lot to benefit yourself, rather than individual shareholders. I am unhappy about the fact that excess shareholder money is essentially increasing the stake of the Walton family, and giving them a disproportionate benefit. If a dividend had been paid, rather than a buyback, each shareholder would have been treated more fairly.

If a major shareholder controls a corporation, they can use their power at the expense of ordinary shareholders. Wal-Mart could become a controlled company. Wal-Mart has stated the following in its filing with the SEC:

although the Walton family holds approximately 51% of our company’s Shares, we have not and do not plan to rely on any of the exemptions from certain board independence requirements available to controlled companies under the NYSE Listed Company Rules. Our Board is committed to maintaining a majority independent Board and believes that this independence ensures robust oversight, independent viewpoints, and promotes the Board’s overall effectiveness

I also wanted to highlight he following passage I found about controlled companies (Source: Harvard Law):

Unlike many global markets, the U.S. — at the state, stock market and federal levels—provides limited protection to minority shareholders. The major U.S. stock exchanges, for example, relax their basic governance listing requirements for “controlled companies.” As a result, governance provisions which provide safeguards for external shareholders, such as a majority of independent directors on their boards or independent nominating panels do not apply to controlled companies. At least partially as a result of this reduced level of accountability to external company shareholders, controlled companies attract disproportionate attention when questionable practices arise.
At other controlled firms, however, the adage about the corrupting qualities of absolute power rings true. At these companies, self-dealing, poor strategic planning, and other risky behaviors destroy value.

I am hopeful that the Walton family preserves the integriry of the board, and treats minority shareholders fairly. I also hope that they do not simply decide to hold on to their stock, until Walmart further increases their controlling stake in the company through share buybacks. They have done this so far, and I am hopeful that they will continue the legacy of Sam Walton. The article was not aimed at the Walton family, but rather to raise a new concern around share buybacks which is not discussed. It is possible that a lot of shareholders do not give much thought to the risk I discussed today.

To summarize, a company can disproportionately benefit a major shareholder by prioritizing buybacks over divide ds. As a result, company slowly takes itself private through share buybacks. This further increase ownership and control of the major shareholder, using resources that could have benefitted all owners through dividends.

Relevant Articles:

Share Buybacks and Dividends Are Not The Same Thing
Dividends versus Share Buybacks/Stock repurchases
Dividends versus Homemade Dividends
Dividends Unlock Value For Shareholders

Popular Posts