The Great Deformation

by David Stockman

  CISCO SYSTEMS: THE GREATEST STOCK-LAUNDERING MACHINE EVER INVENTED

  The poster boy for the extreme rinse-and-repeat form of stock buybacks has undoubtedly been Cisco Systems, one of the original bright stars in the technology firmament which has since grown long in the tooth. Until very recently, it never paid a dime of dividends and its stock price had languished for years at just under $20 per share, a level first reached in November 1998.

  At first blush, the fact of zero returns to shareholders over an entire fifteen-year period seems wildly inconsistent with Cisco’s well-known posture as a heavy buyer of its own stock. In fact, cash spent on buybacks totaled $37 billion during fiscal 2007–2011, enabling it to repurchase approximately 28 percent of its shares.

  This massive buyback amounted to 102 percent of the company’s net income and towered over the mere $6 billion Cisco spent on capital expenditures (CapEx) during that period. This flinty CapEx figure not only represented just half of its depreciation and amortization charges, but was also only 3 percent of its $200 billion in revenue over those five years, a level drastically below the 5–10 percent of sales devoted to capital spending by most of its global technology peers.

  The implication was that boosting its stock price, even at the cost of drastically underinvesting in its productive assets, had now become the preponderant purpose of the technology industry’s former growth dynamo. It is virtually inconceivable, however, that this drastic allocation of cash to the repurchase of its own shares would have occurred in an environment where taxes were on a level playing field and financial markets had not been converted into speculative casinos.

  The worst part of the Cisco story is that despite the repurchase of 1.8 billion shares, the implied drastic shrinkage of its float didn’t happen. The company’s fully diluted share count during this five-year period dropped by only 700 million shares, or by less than 40 percent of its gross buyback.

  The balance of these repurchased shares was recycled back into the company’s various employee stock option plans, which currently have 1.2 billion share equivalents outstanding. Not surprisingly, Cisco’s CEO, John Chambers, has long been an evangelist in behalf of low taxes on capital gains.

  The truth of the matter, however, is that Cisco was running a shareholder-subsidized scheme for transforming the pay of Chambers and his top executives into IRS-proof winnings. Accordingly, during this period Cisco executives, employees, and insiders harvested capital gains from stock options in excess of $15 billion. Self-evidently, these winnings were touched only lightly by the tax man.

  Nor was Cisco Systems an outlier in the buyback game. Between the end of 2004 and the first quarter of 2011, the S&P 500 companies alone completed $2.3 trillion of stock buybacks. This meant that a continuous wave of corporate cash flow was being flushed back into the stock market, thereby placing a potent bid under stock prices while providing generous headroom for the continuous award of new stock options. The top twenty blue chip giants that dominate the S&P 500 were especially voracious purchasers of their own stock, buying back nearly $800 billion during this period.

  The leader was ExxonMobil, which repurchased $160 billion of its own shares during 2004–2011. It was followed by Microsoft at $100 billion, IBM at $75 billion, and Hewlett-Packard, Proctor & Gamble, and Cisco with $50 billion each. Even the floundering shipwreck of merger mania known as Time Warner Inc. bought back $25 billion.

  The standard defense of stock repurchase is that it represents the highest and best use of corporate cash as determined by executives and boards; that is, it is an efficient outcome on the free market. If that’s true, of course, then the massive scale and pervasive extent of stock buybacks during recent times imply that American corporations have run out of plausible growth opportunities. Presumably, they have determined that investments on the floor of the New York Stock Exchange offer higher returns than CapEx on the factory floor or a drill bit on the ocean floor.

  In fact, buybacks are driven by policies of the state far more than by acts of pure capitalism on the free market. Feeding the speculative mob while pocketing low-tax capital gains is what drives CEOs to act. Cheap debt and a stock market badly deformed by the Greenspan-Bernanke Put are what enable the game.

  EXXONMOBIL’S $125 BILLION DRILLING CAMPAIGN ON THE FLOOR OF THE NEW YORK STOCK EXCHANGE

  The case of ExxonMobil, among many others, raises considerable doubt on the proposition that stock buybacks reflect a free market choice. It would be just plain implausible to contend that the world’s largest private energy producer, operating in the context of $100 per barrel of oil, is faced with a paucity of opportunities to reinvest its prodigious cash flow.

  Yet that is exactly what ExxonMobil’s cash deployment patterns imply. Stock buybacks, not capital investment, absorbed the preponderant share of the $175 billion in net income that ExxonMobil generated during 2007–2011.

  The company spent $125 billion on share repurchases over this period, which enabled it to buy in nearly 1.7 billion, or 30 percent, of its outstanding shares. By contrast, capital spending net of depreciation and depletion amounted to less than $50 billion over the same period. This means that, notwithstanding the evident windfall profits that are available from bringing incremental hydrocarbon production on stream, ExxonMobil elected to allocate 70 percent of its net income to drilling for returns on Wall Street.

  This lopsided allocation, however, was not exactly proof that buybacks were ExxonMobil’s highest and best use of cash. This is evident in the fact that the company’s share count shrank only modestly despite this $125 billion tsunami of stock buybacks. Outstanding shares fell by just 17 percent during the entire five-year period, or by a little more than one-half of the gross stock buybacks.

  Given the company’s fulsome trend in executive compensation via stock options, this gap is not all that mysterious: shares were being recycled to insiders, not retired to the company’s treasury. For example, the company’s long-reigning CEO, Rex Tillerson, was paid $150 million over the period, most of it in stock awards.

  The truth of the matter is that the management and board of ExxonMobil, like those of most public companies, are addicted to share buybacks. Buybacks are the giant prop which keeps share prices elevated, existing stock options in the money and the dilutive impact of new awards obfuscated. They are also the corporate laundry where Federal income taxes are rinsed out of top executive compensation through the magic of capital gains.

  IF THE FED HAD NO DOG IN THE STOCK MARKET HUNT

  Several decades of money printing and stock market coddling by the Fed, therefore, has turned the nation’s top corporate executives into stock option hounds. The primary job of CEOs has now become chasing their share prices ever higher by allocating huge amounts of available cash, including the proceeds of borrowings, to financial engineering maneuvers like buybacks. Were the Fed ever to declare it has no dog in the Wall Street hunt and that it is indifferent to the stock averages, the truth of that proposition would become readily apparent.

  Left to their own devices on the free market and on a level tax field, corporate executives would pay cash dividends to provide a return to shareholders. They would reinvest their remaining cash flows to become more competitive, whether through paying off existing debt or acquiring additional productive assets.

  Or in the event they were in a sunset industry, as implied by the buyback addiction of most large US companies, they would use excess cash flows to pay down debt in order to survive. Whatever their external situation, however, corporate executives would not issue huge amounts of debt to chase their share prices higher in order to gorge themselves on stock options; an honest stock market and level tax system wouldn’t let them.

  An honest stock market would also see through the financial engineering game, recognizing that, in the main, stock buybacks have been a camouflage for the lack of true earnings growth. ExxonMobil’s operating results, for example, have been flat as a pancake over the cycle. It earned $41 billion in net inc
ome and $70 billion in EBITDA (earnings before interest, taxes, depreciation, and amortization) during 2007 and posted identical amounts on both measures of income in 2011. So the fact that the company’s EPS rose from $7.26 to $8.42 per share during this four-year period is exclusively due to the share buybacks.

  The cynic might wonder why ExxonMobil paid CEO Rex Tillerson $150 million during a period in which its share price rose by just 3.5 percent annually amidst the greatest bull market in energy industry history. Indeed, owing to policy distortions emanating from the central banking and taxing branches of the state, there is a far more insistent issue: Namely, why is ExxonMobil being operated as a (slowly) liquidating trust? During the past five years it has distributed $165 billion to shareholders in buybacks and dividends, an amount equal to 93 percent of its $175 billion in cumulative net income.

  Perhaps it is a “sunset” company despite the widespread belief that the value of hydrocarbon reserves has nowhere to go except up. Yet under a level tax playing field it is highly unlikely that stock buybacks and stock price pumping would be the preferred strategy for a sunset company. Tax-indifferent shareholders, in particular, might strongly prefer to collect their returns in dividends they could control rather than stock buybacks which elevate stock prices temporarily, but also leave the resulting “paper” gains exposed to open-ended market price risk.

  Under the Greenspan-Bernanke Put, however, true free market risk is heavily discounted, and logically so. Wall Street expects the Fed to keep stock prices propped up at all hazards. So with stock market risk minimized and the tax code heavily biased toward inside buildup and capital gains, ExxonMobil chooses to pay only a modest 2.5 percent dividend and retains the rest of its 10 percent net income yield to fund its massive stock price–pumping operation.

  As the largest and most profitable corporation on planet earth, its strategy fully embodies and promotes the deformations of finance that result from current policy. And if the misguided policies of the state warp and shape the financial model of even mighty ExxonMobil, it cannot be gainsaid that they drive the entire corporate economy. Most of the other great blue chip corporations, in fact, have demonstrated the same pattern.

  PROCTOR AND GAMBLE CO.:

  “DUMP AND PUMP,” CORPORATE STYLE

  The paragon for “dump and pump” corporate finance is the venerable Proctor & Gamble (P&G). During the last five years it has dumped $35 billion of buyback funds into the stock market, and has thereby pumped its stock price modestly; indeed, very modestly. Its share price of $67 at the end of 2011 was up just 4 percent from the $64 level where it stood at the beginning of 2007.

  Even as the share price inched upward, P&G’s income statement went nowhere. During this five-year period its pre-tax income was flat at $15 billion annually, and EBITDA actually declined from $20 billion in 2007 to $17 billion in 2011. The only thing that kept its EPS rising was a drop in its tax rate and a 12 percent shrinkage of its share count.

  Roughly speaking, a liquidating trust is distinguished by the fact that it can pay out more than it earns. In pursuing its “dump and pump” corporate finance strategy, P&G functioned in exactly that manner during the past half decade. Its combined stock buybacks and dividend payments totaled $60 billion, a figure well more than 100 percent of its net income of $55 billion. So, notwithstanding its vaunted brands, the company had implicitly thrown in the towel and was slowly liquidating itself in a strained effort to keep its stock price rising and management stock options above water.

  When a company like P&G implicitly embraces a sunset strategy and chooses not to reinvest in its operating businesses, an infinitely better use for cash would be to pay down debt, since a no-growth enterprise is inherently risky. The Fed’s ultra-low interest rate régime, however, closed that door completely. During the last five years, P&G did not use its massive free cash flow to pay down even a dime of its $30 billion in debt.

  With a market cap of nearly $200 billion, Proctor & Gamble stands at the center of the US corporate sector. Its adoption of a corporate finance model based on dumping cash into buybacks and pumping its stock price, therefore, has broad ramifications. Since this model does not reflect the natural inclinations of the free market but, instead, arises out of bad tax and monetary policies, it is evident that unsustainable bubble finance has penetrated deep into the corporate economy.

  FINANCIAL ENGINEERING RUN AMOK:

  THE LOOTING OF HEWLETT-PACKARD

  Unfortunately, Proctor & Gamble is only a mild case of the financial deformations attendant to these misguided policies of cheap debt and unbalanced taxation. A far more virulent template is found in the tattered financial carcass of Hewlett-Packard, the former powerhouse in the information technology and personal computer industry.

  It has been run for more than a decade now by a succession of CEOs who excelled mainly at appearing on CNBC to tout their stock. Their consistent theme was that the company’s massive share buybacks and serial M&A deals were a sure-fire formula for robust EPS growth and a fabulous upside for shareholders.

  Yet, since the spring of 2010, Hewlett-Packard’s stock price has been savaged because it finally became evident that financial engineering had felled the business operations and balance sheet of one of the nation’s storied technology companies. Indeed, the spectacular collapse of its market cap, which since then has dropped from $120 billion to $30 billion, is a striking rebuke to several generations of Hewlett-Packard CEOs.

  It is also much more. It crystallizes the manner in which the Fed’s fixation on levitating the stock market has lured a whole swath of corporate executives into playing destructive financial engineering games—maneuvers that are further reinforced by the Washington policy bias toward debt and capital gains.

  When Hewlett-Packard’s stock price rolled over at $53 per share in the spring of 2010 and began its unrelenting plunge toward $15, it meant that the company’s share price had retreated all the way back to its June 1997 level. And that was in spite of a massive campaign of financial engineering maneuvers in recent years that had few peers among big-cap technology names.

  During the five years ending in fiscal 2011, Hewlett-Packard repurchased $48 billion of its own stock, even though its net income during the same period was only $39 billion. Furthermore, total shareholder distributions, counting its modest dividends, came to 133 percent of net income. The company’s financial strategy amounted to eating its own tail.

  Distributions to shareholders greatly in excess of net income are rarely a formula for long-term financial health, but in this case were especially counterproductive because Hewlett-Packard was also drastically under-funding its fixed-asset base. It recorded $22 billion of depreciation and amortization charges during this five-year period, compared to only $18 billion of capital expenditure, notwithstanding that it was the largest high-tech equipment manufacturer in the world and faced brutal East Asian competitors who did not usually play by capitalist rules.

  Investors on the free market would have given a thumbs-down to such self-destructive policies long before its stock price rolled over in the spring of 2010. But that had not happened because liquidity-juiced Wall Street speculators had ramped the stock over and over, initiating a new run-up each time another M&A deal was announced or rumored, and whenever the board renewed or extended its massive stock buyback program.

  The promise of huge synergies from acquisitions was a particularly potent catalyst for periodic stock ramps because Wall Street is replete with rumors and inside information about M&A deals. As shown in chapter 23, takeover speculation is one of the crucial inner mechanisms of profit capture in the hedge fund–driven casino which now operates on the stock exchanges.

  In the fullness of time, however, it became evident that the $37 billion that Hewlett-Packard spent on M&A deals during this five-year period did not have the flattering impact on earnings its deal-making CEOs had so loudly advertised. In fact, this M&A spree brought a vast expansion of its corporate footprint and complete dis
order to its business operations and strategy.

  Consequently, even as annual sales surged from $100 billion to nearly $130 billion, nothing at all fell to the bottom line, with net income of $7.3 billion in 2007 remaining flat at $7 billion four years later. Needless to say, when the M&A trick finally failed to satisfy the market’s Pavlovian expectations for growth, the speculators moved on to more promising targets.

  The abysmal failure of Hewlett-Packard’s serial M&A deals became starkly evident when it was recently forced to write-off nearly $20 billion of goodwill and assets for just two acquisitions, Electronic Data Systems and a British company called Autonomy. What was also evident is that in massively overpaying for bad deals, the company had wrecked its balance sheet. During this five-year spree of financial engineering, Hewlett Packard had spent $90 billion on shareholder distributions and M&A deals, but had generated only $45 billion in operating cash flow after capital expenses.

  In short, the stock market–obsessed CEOs of Hewlett Packard had spent twice as much on financial engineering projects as they had available in cash flow. The company’s net debt thus inexorably mushroomed, rising by $25 billion over the period and leaving one of the nation’s technology giants hobbled by the excrescences of bubble finance.

  Here was powerful testimony against the Fed’s “wealth effects” policy and the consequent propping and juicing of the stock averages attendant to it. Owing to these machinations, the stock market was crawling with speculators capable of powerful hit-and-run forays that encouraged CEOs and boards to do their bidding; that is, feed the speculative mob with another stock buyback or M&A deal. Great companies like Hewlett-Packard were now being run not by adult professionals but day-trading punters.

  Boards and CEOs who strap on their helmets and resist the pressure to mete out another “fix” face the real risk of getting swept out by the clamoring herd. Certainly the prospect of harvesting capital gains from stock option winnings, if financial engineering works, and keeping share prices rising is the more appealing scenario.