Share Buybacks That Pay Back in Spades

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

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