By Buying Back Shares, IBM Polishes Image

Considering that its chairman just the day before had predicted flat profits at best for this year, the stock market treated International Business Machines relatively well Thursday. The institutional investors who hold about half of IBM’s stock evidently decided to hold on to their shares and support the company.

Which, you could say, is only fair, since IBM demonstrated a couple of weeks ago that it supports the institutional investors. On May 27, with its stock price touching $143 and heading downward, IBM announced that it would buy in 10 million of its 616 million shares outstanding. It was a minor amount of stock, 1.6% of the total, to be bought for less than $1.5 billion--an amount that IBM could take out of its cash drawer. But investors were immediately grateful, sending IBM’s price back up over $150 in the days following the announcement.

The temporary gain was less significant--the price has since dipped back to the mid-$140s--than the fact that IBM, far from being above the battle, had acknowledged the importance of box-office appeal. “There’s competition,” notes Michael Geran, a computer industry analyst for E. F. Hutton. “Digital (Equipment) and NCR were getting the market’s attention, so IBM reached out.”

Lift Price of Stock

The computer giant thus joined the ranks of companies--more than 800 last year--that annually buy in a portion of their stock. Why do they do it? All sorts of reasons: to acquire shares for stock option plans or employee ownership plans, to insulate the company against raiders or to help a family trust cash in a large block of shares. Sometimes the intent, and almost always the effect, is to lift the price of the stock.

Here’s how that works. After a repurchase, there are fewer shares outstanding, which means fewer shares to divide into the company’s total profit in order to calculate the earnings per share. This tends, all other things being equal, to increase the earnings-per-share figure and, thus, the stock price--which is customarily a multiple of earnings per share.

Yes, but is it real? Such mathematical ingenuity seems only to confirm James Abegglen’s caustic characterization of the American corporation as “an alliance of senior management and shareholders to optimize current earnings from the company to mutual benefit.”

Abegglen, an American management consultant who has worked in Japan for more than 20 years, points out in his book, “Kaisha, the Japanese Corporation,” that such pandering to shareholders would be unthinkable in Japan. The Japanese stockholder is entitled to a dividend but no further voice in company affairs. The business is run by management, which invests constantly--subject to the permission of Japanese banks--to gain markets for the company’s products.

Can Return Cash Flow

So, is share repurchase another, sigh, example of U.S. myopia compared to Japanese vision? Not necessarily. Japanese investment policies can lead to excess, too. The country is burdened with massive overcapacity in steel, for example. U.S. companies, on the other hand, are able to prune operations in bad times by returning some cash flow to those shareholders who wish to sell. Those who don’t sell gain a correspondingly larger share of stockholders’ equity.

That, in a sense, is what Union Pacific is doing at the moment. The giant railroad and natural resources company announced last week that it would lay out $750 million in the next two years to purchase its own stock. UP, which also is taking a writedown of almost $1 billion this year on the value of a Corpus Christi, Tex., refinery and other oil and gas holdings, is saying that business in its Western railroad regions may not be outstanding for the next couple of years.

So, rather than continuing to expand in a period of decline, UP is contracting--shrinking the equity base--to await better opportunities. Say this: It beats paying big money to other companies’ shareholders for questionable acquisitions.

Why not simply pay a bigger dividend? The current tax laws, mainly. The income to pay the dividend is taxed when the company earns it and the dividend is taxed as ordinary income to individual recipients. New tax legislation eliminating the capital gains preference would put stock buybacks and dividends on an equal tax footing, but stock repurchases probably will continue to appeal to companies.

The model there is Exxon, which decided, after bitter experience with diversification, to start buying in shares in 1983. The oil giant has since paid out almost $7 billion to repurchase about 140 million shares, a massive support for its stock in recent years.

Now, back to IBM and more business arithmetic. The computer company earns about a 20% return on every dollar that it invests in its business. For each share of stock that it buys back, IBM is really buying back about $10 in earnings for a price of about $140. That is a return of roughly 7%.

What does that mean? Either that IBM’s management made a dumb investment or that it foresees appreciably higher earnings. Probably the latter.