In my recent Wal-Mart article, I mentioned that one of the risks of owning stock in a company reliant on share repurchases is that there is little recourse left when business conditions deteriorate and there is not enough retained earnings to continue executing a repurchase-reliant strategy to build shareholder wealth.
To get a glimpse of a real-life example, take a look at what is going on at ExxonMobil right now. Between 2000 and 2014, ExxonMobil retired enormous amounts of stock. Exxon had 6.9 billion shares outstanding in 2000, and reduced it to 4.2 billion by 2014. Those 2.7 billion retired shares ended up reducing the share count by 3.5% annually.
In 2000, Exxon was generating $16 billion in profit. By 2014? $32 billion. Based on profits alone, you would have expected earnings to grow from $2.41 to $4.82 over those fourteen years. But because the Exxon share count was lower, Exxon’s 2014 earnings were actually $7.60 per share. That lunge in per share profitability from $4.82 to $7.60 was the result of Exxon’s extensive share repurchase program during those 14 years.
Over that same time, the Exxon Board of Directors voted to increase the annual per share dividend from $0.88 in 2000 to $2.70 in 2014. This tripling of the dividend only ended up constituting 35% of Exxon’s overall profits in 2014 instead of 56%. That’s how the share repurchases facilitated the growth of the dividend.
However, since 2014, Exxon has not been able to repurchase shares as the price of oil has fallen. It repurchased 50 million shares during the front end of that year, and the share count has remained at 4.1 billion shares since then.
That was the prudent course of action because Exxon needed to borrow substantially in order to fund its capital expenditures plus its dividend. In early 2014, Exxon only had $7 billion in debt while it was making $32 billion in profit. Now, it has $43 billion in debt while only making $11 billion in profit. That comparison is a capsule summary of the effects that this oil downturn has had on the mega-cap integrated energy firms.
I take three lessons from this experience that can be applied to large-cap, blue-chip stocks:
First, it is very important to build up a strong balance sheet during the good times. The reason I criticize companies like Simon Property for not deleveraging quicker during the aftermath of the Great Recession is that it creates a position of strength when the next recession arrives. Imagine if, in early 2014, Exxon was sitting on $40 billion in debt. It would be appraised quite differently if it had to take on a cumulative debt burden of $80 billion (it would be acting more like Shell right now, having to discard long-term promising assets that don’t offer a short-term payoff while also dealing with intense speculation about the dividend).
Second, it is easy to understand why Siegel’s data on the superiority of dividends compared to buybacks makes intuitive. As a matter of theory, it is easy to talk about the tax advantages of share repurchases over dividends and the fact that share repurchases at low valuations enhances returns. Well, when times get tough, the share repurchases stop before the dividend gets cut. Exxon shareholders have a reinvested dividend at $73 per share, but there were no corporate actions to repurchase the stock when it was attractive at that price. It was wise of Exxon to do so, but you can still observe how Exxon’s dividend contributed to 2015 and 2016 while there was no repurchase program to do likewise.
Third, Exxon’s future dividend growth will be under stress without the accompaniment of buybacks. When oil prices rise, Exxon may want to pay down its debt and re-establish its balance sheet strength, turn on the spigot of idling projects, and only then return to share repurchases to get earnings per share up before raising the dividend. A buyback-focused company needs to wait for the storm to pass before it can responsibly give shareholders meaningful dividend hikes. Absent a significant rise in the price of oil, I project Exxon’s dividend will grow at around 4% per year until oil crosses $75 per barrel and stays there for a long period of time.