How some companies manipulate share buybacks to inflate earnings
September 24th, 2018 by Jason B. Vanclef
Not all company share-buybacks are created equal.
Investors can gain a crucial advantage by taking this into account. And it takes surprisingly little effort to do so: less than 10 minutes of analysis whenever a monitored company reports earnings.
These are the fascinating conclusions of new research into a type of buyback known as an “Accelerated Share Repurchase.” These buybacks are like the more traditional share repurchase, except that they are executed all at once rather than gradually in the open market.
ASRs are made possible because an investment bank is willing to borrow the requisite number of shares from institutional investors and then sell them as a block to the company. That bank will then cover its short position by itself gradually buying back those shares over a several-month period in the open market.
Over the past 15 years, an increasing percentage of share buybacks have been in the form of ASRs. In 2017, for example, about 10.5% of all share repurchases were ASRs. Moreover, the typical ASR is not tiny, according to Ahmet Kurt, an assistant professor of Accounting at Suffolk University and the author of this new study; it instead reduces a company’s share count by 5% — overnight.
Why the rush?
That’s a big share reduction to happen all at once, and Professor Kurt’s research was motivated in large part by the simple question: “Why the rush?” The answer, he discovered in his research: In many cases, a company that resorts to an ASR is on the brink of reporting earnings that will miss the consensus forecast.
Notice that in such a case a traditional share repurchase program won’t be enough to change that earnings miss into a beat. That’s because the share count will be reduced over a long period — typically many months if not longer into the future. To change an earnings miss into a beat, the share count has to be reduced immediately.
Enter the ASR.
To show that this surreptitious motive is behind many ASRs, Kurt examined 293 ASR transactions that were conducted over the eight years through 2011. He found that, in 29% of the cases, the company would have missed the consensus earnings forecast but for the ASR that occurred prior to the end of the earnings reporting period. That rate was more than twice as high as the comparable one for companies engaged in regular share repurchase programs.
Some CEOs are managing their companies’ buyback programs in order to increase their bonuses.
That result was suggestive enough, but the real smoking gun came when Kurt examined whether the likelihood of a company turning to an ASR was correlated with whether its CEO’s bonus payment was contingent on EPS performance. It was.
Your blood should be boiling as you read this. It means that some CEOs are managing their companies’ buyback programs in order to increase their bonuses.
Another factor that increased the likelihood of a company using an ASR to goose earnings, according to Kurt: Whether the company has had a long history of equaling or beating the earnings consensus. As with whether a CEO’s bonus was dependent on EPS performance, this additional factor also doubled the likelihood of a company using an ASR to manage earnings.
As you might imagine, companies using ASRs to manipulate earnings are engaging in financial engineering for cosmetic purposes rather than promoting genuine long-term value for shareholders. Value-oriented investors might want to avoid them.
To illustrate, Kurt constructed two hypothetical portfolios. The first contained firms that appeared to be using ASRs to manipulate earnings, as evidenced by factors like basing its CEO compensation on EPS performance. The second contained firms that appeared to have used ASRs to promote long-term value.
The latter portfolio outperformed the former, in terms of operating performance, by 3.9 percentage points over the two years subsequent to the ASR.
How can investors put this insight into practice? Here are the steps Kurt suggests we take when a company reports that it has met or exceeded the earnings consensus:
- Determine if the firm engaged in an ASR during the period covered by the earnings report. A Google search on the company’s name and “Accelerated Share Repurchase” is all that is required.
- If the company did engage in an ASR, calculate what its EPS would have been had the ASR not occurred. This is calculated by dividing two numbers:
- The numerator is the addition of two numbers: The company’s net income, and what the company spent on its ASR.
- The denominator is the addition of two numbers: The number of shares the company had outstanding at the end of the reporting period, and the number of shares that were bought pursuant to the ASR. (You should adjust this latter number according to when, in the reporting period, the ASR occurred; if the ASR occurred with just one month left in a quarter, for example, you would multiply the number of shares of the ASR by one third.)
If the EPS that emerges from this calculation is below the consensus forecast, and the reported EPS met or slightly exceeded it, then it’s a good bet that the company was motivated in its ASR by manipulating the EPS. That’s a warning sign.
Don’t get scared away by the seeming complexity of these calculations. Kurt points out that it can take less than 10 minutes. The potential reward of doing the calculations could make that work well-worth the effort.