Defending Ron Johnson — The Acts That Preceded

Why does a company buy back its own stock?

There are a number of reasons. You could say that all are good reasons, depending on your point of view. When a company announces a stock buyback, you should immediately ask cui bono? Who will benefit from this action?

For a stock buyback, the standard answer to cui bono is “the shareholders of the stock.” The classic argument goes like this: “The Company takes shares off the market, and with fewer shares, the company is worth more, and the stock price will rise.” Somewhat in the same construct is the effect fewer shares on the market have on earnings per share (EPS): fewer shares increases EPS, making the stock look more attractive, and that will increase the stock price.

Remember what the guy on the front of the $5 bill said? “You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time.” (Some argue that Lincoln never said this line in his 1858 Clinton, Illinois speech.) Share buyback programs may have worked like the conventional wisdom above outlines when they were first used, but looking at the performance of most buyback plans, most fail to deliver improved shareholder value.

If a share buyback does not benefit the stockholders, whom does it benefit? Perhaps we should look to the people making the recommendation — management.

The JC Penney 2011 Example

In early 2011, JC Penney bought back over 24 million shares of company stock on the open market for about $839 million. The company spent $839 million in cash to purchase the 24.4 million shares.

So, what happened to the stock price? On February 25, 2011, the company announced the buyback of $900 million of stock on the open market. The stock closed at $34.16 that day. The little blue dot on the chart marks the announcement date, and we can see that the price climbed as much as $5 a share after the company bought the stock. The buyback came after the announcement of shareholder agreements with both Bill Ackman’s Pershing Square Management and Steven Roth’s Vernado Trust.

Still, by the end of the summer, the stock returned to below $31, which is where it was before the 2011 results published.

Cui bono, JCP? Who benefited? I am sure that some stockholders who sold their shares made profits when the company was buying. But not all stockholders did. Still, the management of the company — who made the decision to spend the company’s assets to buy back the equity — benefited rather handsomely.

All the JC Penney executive officers, other than Mike Ullman, then JCP CEO, received 43% of their total 2010 compensation through equity grants. Those grants consisted of 50% stock options, 25% time-vesting restricted stock units (RSUs) and 25% performance-based RSUs (based on earning per share).

Companies grant nontransferable restricted stock to an executive subject to forfeiture under certain conditions, like termination of employment or failure to meet company or personal goals. Restricted stocks are almost always granted under some vesting period, and as the shares vest, the employee gains voting rights. An RSU is like a restricted stock, but with some twists. RSUs represent an unsecured promise by the employer to grant shares of stock to the executive at the end of the vesting schedule. The executive does not earn the shares until the end of the vesting period, when forfeiture requirements are released. RSUs do not grant any voting rights, since the grantee does not own the shares.

The JCP executives got half of their 2010 equity grant from RSUs, where the granting trigger for half of the RSUs was the EPS performance of the company. A stock buyback benefits the executives who hold both stock options and performance shares, because fewer outstanding shares will boost earnings per share calculations.

Shifting the EPS up by eliminating 24 million shares could move the EPS as much as 65%. In essence, the executives and the board of directors burned $900 million of JCP cash to help boost their own equity compensation.

Other Avenues

Management could have chosen different avenues to spend the company’s money.

In 2011 JCP bought the rights to the Liz Claiborne fashion line of apparel. Management could have doubled down and picked up another line, perhaps in men’s clothing. Any number of designer lines are available for the right money, all that could have lifted Polyester Penney’s image… and revenues.

Deploying the cash to upgrade the physical plant, upgrading stores, or fixing the poor performance and alignment of the catalogue and e-commerce divisions — any of these could have been another path to take with the money. Higher dividends could have been a great reward for those shareholders who held on to the stock, which would have created more demand for resale of the stock to generate more capital if needed later. The company could have banked the cash, holding it as a rainy-day fund to weather future storms.

What the JC Penney management spent on the stock buyback in 2011 did not help the company or the shareholders. It only helped the senior executives. And those are the executives whom Ron Johnson promoted to customer in 2012.

For more on how the numbers work, read this great article by Robert Zingale in the October 2011 Seeking Alpha article.

Defending Ron Johnson – The Numbers

Defending Ron Johnson – Bucking Doctrine