Buybacks and Debt

One advantage for investors and corporations is to be really good at boring stuff. Two things that are boring are capital structure and capital allocation. There are no Apple or Tesla-like events to unveil new strategies for mixing debt and equity, although such an event is funny to imagine.

I’ve written about buybacks (here and here) and how high conviction buyback programs (conducted at cheap relative valuations) have historically signaled good investment opportunities.

A common objection to this “high conviction buyback” strategy is that companies just issue debt to buy back shares, and that the party may end with higher interest rates (you know, the ones right over the horizon).

So are those repurchasing their shares becoming irresponsibly levered to do so? All of what follows is for all U.S. stocks with market caps above $200MM and excludes financial companies.

A Story in Charts

Firms have bought back a lot of stock since the financial crisis. Here is the amount firms have spent on a rolling 12-month basis on gross buybacks, alongside how much they’ve raised by issuing shares (shown as a negative number). The two numbers are combined to get the “net buybacks” line.

buyback issue

Some companies—most notably Apple—have issued tons of debt and simultaneously bought back stock. This is an easy way for a company to change its capital structure. In Apple’s case it may be due to the amount of cash they have overseas, on which they prefer not to be taxed. The number one question I get about the shareholder yield factor is whether or not this debt-funding-buybacks is a big issue and something that should scare us. Asked differently, are companies that are taking on more debt to buy back shares ticking time bombs?

A company gets money from three places: from positive cash flow through its normal business (earnings, basically), from issuing debt, and from issuing equity. There is a “pecking order” for these three options. Companies prefer to finance themselves with internally generated cash first, debt second, and precious equity third.

Here is a comparison of total debt issuance and total equity issuance over the past few decades. You can see that firms vastly prefer to use debt financing, and that there has been a huge surge in debt issued (again on a rolling one year basis) since the financial crisis.

pecking order

This rise in rolling debt issuance looks scary, but debt is one thing and interest is another. Rates have fallen while operating earnings have continued to grow. Here is the ratio of operating earnings (EBIT) to total interest expense for U.S. firms.

market int burden

Of course, this drop has happened alongside a steady drop in general interest rates. But it doesn’t exactly look like companies are being reckless.

Buyback Companies vs. Non-Buyback Companies

Let’s create two groups:

  1. Companies that haven’t bought back shares (net buyback yields <=0). Many of these are issuing shares.
  2. Companies with positive net buybacks (buyback yields >0)

We can look at debt in a few different ways for these groups. There is some choppiness to these lines because companies can flip back and forth from one group to the other, but the overall trends are clear.

First, here is the overall debt/equity ratio. The firms buying back shares are less levered.

debt equity all

Here is interest as a percent of operating earnings (interest expense/EBIT), again the companies buying back shares are less levered; they have a smaller interest burden.

interest burden all

Finally, here is the net debt yield of both groups. This yield is calculated as net new debt (issuance minus paydown) divided by total debt. The groups look roughly similar. This means that the buyback companies aren’t really issuing new debt at a higher rate than non-buyback companies.

net debt yield all

If you buy an index fund, you are levered because companies use leverage.  There is no reason to assume that more debt is a bad thing. It’s been a really cheap source of financing, and it even has tax benefits. Even if you isolate the group down to what I call “high conviction” buyback stocks (those repurchasing more than 5% of their shares in the past year), the numbers all look similar. Debt/equity is 1.45x for this group, less than the market’s 1.6x. The net debt yield is 11%, just a point above the market’s 10%. Ditto for interest burden: high conviction companies spend the equivalent of 11% of their operating earnings on interest expense, while the entire U.S. market spends 16%.

There is way too much nuance within corporate finance to paint the market with a broad brush. Perhaps corporate managers aren’t all dummies and several have instead used the less-than-glamour side of their jobs—managing capital structure and allocating capital—to benefit their shareholders.