To call SocGen’s Andrew Lapthorne an ardent critic of financial engineering would be to grossly understate the case.
For years, Lapthorne has criticized the leveraging of corporate balance sheets to repurchase inflated shares. If there is one theme that pervades Andrew’s research, it’s that rising corporate debt is clearly linked to buybacks, and to the extent excessive leverage is inherently a bad thing, it’s even worse when employed in the service of “artificially” boosting share prices and EPS.
“Borrowing money to buy back your elevated shares is clearly nonsense”, he famously wrote, some years back.
In March, Lapthorne scrutinized what he suggested is a misguided approach to conceptualizing corporate leverage. That was but the latest example of his efforts to dispense with the idea that financial engineering isn’t as big of an issue as critics suggest.
Well, in a note dated Monday, Lapthorne warns that “US net debt is once again rising at a near record pace [with] 80% courtesy of new debt.”
(SocGen)
Back in January, JPMorgan’s Dubravko Lakos-Bujas remarked on the rising “quality” of buybacks, where that means share repurchases are increasingly funded with cash, as opposed to debt. “Buyback executions in 2018 have been some of the highest quality of this cycle as they have been predominantly funded by cash rather than debt, a trend we expect to persist into 2019”, he wrote, referencing the following visual.
(JPMorgan)
Obviously, some of that was down to the tax cuts, repatriation and surging corporate profit growth. On Monday, SocGen’s Lapthorne cautioned that “cash on US balance sheets is now falling rapidly”.
(SocGen)
That raises questions about how corporate management teams will fund buybacks, especially in the event debt markets become less forgiving later this year. “US companies will likely increasingly struggle to afford the announced $800bn in buybacks”, Lapthorne contends.
During the Q1 rally, buybacks played a pivotal role, as key investor cohorts remained sidelined thanks to some lingering PTSD from the Q4 rout.
Remember, when it comes to sources of equity demand, it’s not even close…
(Goldman)
Read more: It’s (Still) About The Buybacks
WOW! The chart from Goldman does not give a lot of hope. Basically the only reason we haven’t had the second leg of the great recession is because of price agnostic buying from buybacks.
Also a friendly reminder that the buyback blackout window starts rolling in next week. Yay?
I agree with Lapthorne. My problem, however silly is must seem, is what to do with firms who have bought back so much overpriced stock that they no longer have a positive book value (see Kimberly Clark and many others). In the old days, when I was a finance prof, we used to call that insolvency. Credit rating agencies like Moody’s would look at such a B/S and reduce the credit ratings of such firms, those that owe more than they have in assets, to junk. Because they bought back the stock at more than its book value per share, there is still some left on the market. But that stock doesn’t belong to the company and it can’t be used by the company to pay its bills (what we used to call debts). So how does the firm pay back its debts when they come due? It uses some cash, if it has any left, or it issues new debt. I don’t want any of that. Hopefully the firm makes a profit — if not it is well and truly bankrupt — and gets some more cash. Trouble is it needs that cash to pay for CAPEX, if it still does that kind of thing, and paying off those pesky debts that come due. In any case what financial engineering does is reduce a firm’s financial flexibility. This whole bunch of crap is artificially inflating share prices to enrich CEOs, who God knows need it, poor babies, so they can buy another eight digit house and treat themselves to a nice new $25k watch. All these buybacks reduce CAPEX, causes workers to get laid off, and continues the trend of no growth real income. If this keeps up too much longer some folks are going to get very pissed and the worm may turn once again, and not to another Trump. Check it out.
There is an optimal capital structure depending on the business. One should structure their bal sheet in order to reach the lowest WACC. Some debt is therefore appropriate and too much should be reflected in a higher cost of equity (in theory). Many corps are missing the optimal sadly today.