(Reuters) - Stock buybacks among large U.S. multinationals are poised to reach their highest level since the recession once third-quarter results are done, as companies step up repurchases to take advantage of lower stock prices.
The increase, however, raises several questions for investors because buybacks can make earnings look more robust than they really are, and because more money spent on shares means less invested in the business.
Even institutional investors may not fully appreciate the effect buybacks have on earnings, said Howard Silverblatt, senior index analyst at Standard & Poor‘s.
Companies are “going to spend what they need to do to protect earnings.” he said.
Buybacks among S&P 500 companies slumped from 2007 to 2008, when the United States entered a recession, and bottomed in the second quarter of 2009. They have risen steadily since then, notching up eight consecutive quarters of sequential gains, according to S&P, which says the third-quarter total may top the second-quarter’s $109 billion.
In the second quarter, the most recent for which S&P provided data, buybacks accounted for just under 1 percent of the S&P 500’s total market capitalization. At their decade peak, in third quarter 2007, buybacks accounted for 1.3 percent of the S&P 500’s market cap.
The majority of U.S. companies that have reported third-quarter results so far have beaten Wall Street forecasts, many by just a penny or two per share. Pressure to make the number is no less intense when the economy is lousy.
Buying back stock when prices are low can be smart, but the scale of recent buybacks raises questions about the quality of earnings beats, analysts and investors said. Buying stock may foster shorter-term thinking in the management suite as executives use cash, or raise debt, to buy equity when the business may need additional investment.
Investors are not sensitive enough to know easily how a company can tack on a couple of cents to their earnings-per-share by lowering the share count, said Kevin Beech, manager of equity analysis at Behind the Numbers, a research provider.
“If management has done a deep dive and feels it’s the best use of funds, that’s one thing,” Beech said. “But companies from time to time use, not chicanery necessarily, but accounting help and Band-Aids, to hit their numbers.”
Through the third quarter, U.S. companies authorized more than $400 billion in stock repurchases, up by nearly half over 2010’s year-to-date total, according to Birinyi Associates.
They include Lowe’s (LOW.N), Berkshire Hathaway (BRKa.N), Coca-Cola (KO.N), Goldman Sachs (GS.N), DuPont DD.N and Navistar (NAV.N). IBM (IBM.N) and Intel (INTC.O) and 3M Co (MMM.N) are committing billions.
Buybacks rose steadily in August then flattened, but last week reached a 13-week high of $16.4 billion, averaging $3.3 billion a day. Some jumped too soon as weekly buybacks peaked in late April, when the S&P 500 index .SPX was near highs for the year.
For a graphic, see link.reuters.com/wuz64s
In 2004 and 2005, investors rewarded companies that reduced share count, so buybacks soared, but by 2008 nervous companies reduced or stopped such programs, Silverblatt said. These days, companies are negating stock options or shares used for acquisitions, but are not yet broadly reducing share counts.
“Companies are not making that leap yet,” he said. “The question is, is the trend starting? Is Occupy Buyback starting up again? If we get more certainty and less uncertainty, yes.”
Some buybacks are more effective than others. Netflix (NFLX.O) bought back shares at an average price above $200 in the third quarter. Its stock fell below $80 this week.
If the current pace continues, EPS could get a sizable boost next earnings season, said Trim Tabs, which analyzes stock market liquidity.
Some companies may be playing a quarter-by-quarter earnings game, but that is hard to prove, said Leon Mirochnik, research analyst and associate portfolio manager at Trim Tabs.
“Long-term, I don’t think it’s in their interest,” he said. “It’s not a sustainable measure of earnings power.”
The recent increase in buybacks reflects a lack of confidence in the economy, so companies’ own shares look like a better bet than other investments, Mirochnik said.
“At the moment, I think they’re doing the right thing from a capital structure perspective,” he said.
Mirochnik added, however, that corporate insiders are selling more than they are buying, even as their companies spend big. When executives and companies are both buying, that combination is a strong predictor of future stock gains, but that is not happening now.
Buybacks can substantially lift reported results.
Praxair Inc’s (PX.N) third-quarter profit rose 14 percent, EPS by 16 percent, as the industrial gas supplier bought back 2 percent of its stock. Praxair acknowledged buybacks lifted results and said it plans more.
“Earnings per share grew faster than net income due to share repurchases,” Chief Financial Officer James Sawyer said.
Rival Airgas Inc’s ARG.N net income rose 17 percent, but EPS jumped 29 percent. At least one analyst cited the buyback as a reason for Airgas’s 1-cent earnings beat.
Motorola Solutions (MSI.N) bought back $744 million in the quarter. Asked whether that was to boost EPS, Chief Executive Greg Brown said, “Smart investors see right through that.”
When Dr Pepper Snapple Group Inc (DPS.N) reported results on Wednesday, it had 218 million shares outstanding, down 22 million from a year ago. Credit Suisse analyst Carlos Laboy said earnings got a 2-cent boost from that lower share count, which helped the company beat expectations by 1 cent.
Illinois Tool Works (ITW.N), whose profit beat by 2 cents, spent $1 billion this year buying back shares that at one point were down by a third from their 52-week peak.
That discount “made it pretty attractive for them to do that, and it also highlights potentially some challenges in the market to meet their guidance,” said Jeff Windau, industrials analyst at Edward Jones.
Additional reporting by Martinne Geller, Krishna Das, Lewis Krauskopf, David Gaffen, Ernest Scheyder and Sinead Carew in New York, John Stoll in Detroit, Scott Malone in Boston; Editing by Bernard Orr